AMBAC FINANCIAL GROUP INC - Annual Report: 2008 (Form 10-K)

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

(Mark One)

For the fiscal year ended December 31, 2008

For the transition period from              to             

Commission file number 1-10777

Ambac Financial Group, Inc.

(Exact name of Registrant as specified in its charter)

(212) 668-0340

(Registrant’s telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act:

Securities registered pursuant to Section 12(g) of the Act: None

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes  ¨    No  x

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Act.    Yes  ¨    No  x

Indicate by check mark whether the Registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes  ¨    No  x    

The aggregate market value of voting stock held by non-affiliates of the Registrant as of the close of business on June 30, 2008 was $383,894,359 (based upon the closing price of the Registrant’s shares on the New York Stock Exchange on that date, which was $1.34). For purposes of this information, the outstanding shares of Common Stock which were owned by all directors and executive officers of the Registrant were deemed to be shares of Common Stock held by affiliates.

As of March 2, 2009, 287,345,579 shares of Common Stock, par value $0.01 per share, (net of 7,013,529 treasury shares) were outstanding.

Documents Incorporated By Reference

Portions of Ambac Financial Group, Inc.’s Proxy Statement for its 2009 Annual Meeting of Stockholders scheduled to be held on May 5, 2009 are incorporated by reference into the Annual Report on Form 10-K in response to Part III, Items 10, 11, 12 and 14.

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CAUTIONARY STATEMENT PURSUANT TO THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995

In this Annual Report, we have included statements that may constitute “forward-looking statements” within the meaning of the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Words such as “estimate,” “expect,” “project,” “plan,” “believe,” “anticipate,” “intend,” “planned,” “potential” and similar expressions, or future or conditional verbs such as “will,” “should,” “would,” “could,” and “may”, or the negative of those expressions or verbs, identify forward-looking statements. We caution readers that these statements are not guarantees of future performance. Forward-looking statements are not historical facts but instead represent only our beliefs regarding future events, which, by their nature, may be inherently uncertain and some of which may be outside our control. These statements may relate to plans and objectives with respect to the future, among other things which may change. We are alerting you to the possibility that our actual results may differ, possibly materially, from the expected objectives or anticipated results that may be suggested, expressed or implied by these forward-looking statements. Important factors that could cause our results to differ, possibly materially, from those indicated in the forward-looking statements include, among others, those discussed under “Risk Factors” in Part I, Item 1A of the Annual Report on Form 10-K.

Any or all of management’s forward-looking statements here or in other publications may turn out to be incorrect and are based on Ambac management’s current belief or opinions. Ambac’s actual results may vary materially, and there are no guarantees about the performance of Ambac’s securities. Among events, risks, uncertainties or factors that could cause actual results to differ materially are: (1) difficult economic conditions, which may not improve in the near future, and adverse changes in the economic, credit, foreign currency or interest rate environment in the United States and abroad; (2) the actions of the U.S. Government, Federal Reserve and other government and regulatory bodies to stabilize the financial markets; (3) the risk that market risks impact assets in our investment portfolio or the value of our assets posted as collateral in respect of investment agreements and interest rate swap and currency swap transactions; (4) changes in Ambac’s and/or Ambac Assurance’s credit or financial strength ratings; (5) risks relating to the re-launch of Connie Lee as Everspan Financial Guaranty Corp.; (6) competitive conditions, pricing levels and reduction in demand for financial guarantee products; (7) credit and liquidity risks due to unscheduled and unanticipated withdrawals on investment agreements; (8) inadequacy of reserves established for losses and loss expenses; (9) changes in capital requirements whether resulting from downgrades in our insured portfolio or changes in rating agencies’ rating criteria or other reasons; (10) the risk that we may be required to raise additional capital, which could have a dilutive effect on our outstanding equity capital and/or future earnings; (11) our ability or inability to raise additional capital, including the risks that regulatory or other approvals for any plan to raise capital are not obtained, or that various conditions to such a plan, either imposed by third parties or imposed by Ambac or its Board of Directors, are not satisfied and thus potentially necessary capital raising transactions do not occur, or the risk that for other reasons the Company cannot accomplish any potentially necessary capital raising transactions; (12) credit risk throughout our business, including credit risk related to residential mortgage-backed securities and collateralized debt obligations (“CDOs”) and large single exposures to reinsurers; (13) market spreads and pricing on insured CDOs and other derivative products insured or issued by Ambac; (14) the risk that holders of debt securities or counterparties on credit default swaps or other similar agreements seek to declare events of default or seek judicial relief or bring claims alleging violation or breach of covenants by Ambac or one of its subsidiaries; (15) default by one or more of Ambac Assurance’s portfolio investments, insured counterparties or reinsurers; (16) Ambac’s financial position and lack of financial flexibility, resulting principally from the uncertainty of Ambac Assurance’s ability to pay dividends to Ambac without the consent of the office of the Commissioner of Insurance of the State of Wisconsin; (17) legislative and regulatory developments, including the Troubled Asset Relief Program and other programs under the Emergency Economic Stabilization Act and other similar programs; (18) changes in accounting principles or practices relating to the financial guarantee industry or that may impact Ambac’s reported financial results; (19) changes in expectations regarding future realization of gross deferred tax assets; (20) the risk of volatility in income and earnings, including volatility due to the application of fair value accounting, or SFAS 133, to the portion of our credit enhancement business which is executed in credit derivative form; (21) the risk that our underwriting and risk management

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policies and practices do not anticipate certain risks and/or the magnitude of potential for loss as a result of unforeseen risks; (22) operational risks, including with respect to internal processes, risk models, systems and employees; (23) factors that may influence the amount of installment premiums paid to Ambac; (24) the risk of litigation and regulatory inquiries or investigations, and the risk of adverse outcomes in connection therewith, which could have a material adverse effect on our business, operations, financial position, profitability or cash flows; (25) changes in tax laws, (26) other factors described in the Risk Factors section in Part I, Item 1A of this Annual Report on Form 10-K for the fiscal year ended December 31, 2008 and also disclosed from time to time by Ambac in its subsequent reports on Form 10-Q and Form 8-K, which are or will be available on the Ambac website at www.ambac.com and at the SEC’s website, www.sec.gov; and (27) other risks and uncertainties that have not been identified at this time. Readers are cautioned that forward-looking statements speak only as of the date they are made and that Ambac does not undertake to update forward-looking statements to reflect circumstances or events that arise after the date the statements are made. You are therefore advised to consult any further disclosures we make on related subjects in Ambac’s reports to the SEC.

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Part I

INTRODUCTION

Ambac Financial Group, Inc., headquartered in New York City, is a holding company incorporated in the state of Delaware. Ambac was incorporated on April 29, 1991. Ambac, through its subsidiaries, provides financial guarantees and financial services to clients in both the public and private sectors around the world. The long-term senior unsecured debt of Ambac is rated BBB with a negative outlook by Standard & Poor’s Ratings Service, a division of the McGraw-Hill Companies, Inc. (“S&P”), and Ba1 on review for possible downgrade by Moody’s Investors Services, Inc. (“Moody’s”). Ambac’s activities are divided into two business segments: (i) Financial Guarantee and (ii) Financial Services.

Ambac has historically provided financial guarantee insurance for public and structured finance obligations through its principal operating subsidiary, Ambac Assurance Corporation (“Ambac Assurance”). Ambac Assurance’s financial strength ratings were downgraded during 2008; it now has a Baa1 financial strength rating on review for possible downgrade from Moody’s and is rated A with a negative outlook from S&P. As a result of these rating agency actions, as well as investor concern with respect to these actions, Ambac Assurance and its operating subsidiaries have been able to originate only a de minimis amount of new financial guarantee business since November 2007.

Ambac Assurance has two financial guarantee insurance operating subsidiaries, Ambac Assurance UK Limited (“Ambac UK”) and Everspan Financial Guarantee Corp. (previously Connie Lee Insurance Company) (“Everspan”). Ambac UK, insures a wide array of obligations in the international markets including infrastructure financings, asset-securitizations, CDOs, utility obligations, whole business securitizations (e.g. securitizations of substantially all of the operating assets of a corporation) and other obligations, generally within Western Europe. Everspan is a financial guarantee insurance company that was purchased by Ambac Assurance in 1997 and placed into runoff. Ambac Assurance is seeking to capitalize and reactivate Everspan to allow it to write new financial guarantee business in the U.S. public finance and regulated utility markets.

As an alternative to financial guarantee insurance, credit protection was provided by Ambac Credit Products LLC (“Ambac Credit Products”), a subsidiary of Ambac Assurance, in credit derivative format. Ambac Assurance insures the obligations of Ambac Credit Products under these transactions. These credit derivatives, which are privately negotiated contracts, provide the counterparty with credit protection against the occurrence of a specific event such as a payment default or bankruptcy relating to an underlying obligation. Upon a credit event, Ambac Credit Products is generally required to make payments equal to the difference between the scheduled debt service payment and the actual payment made by the issuer. In a small number of transactions, Ambac Credit Products is required to (i) make a payment equal to the difference between the par value and market value of the underlying obligation or (ii) purchase the underlying obligation at its par value, realizing a loss for the difference between the par and market value of the underlying obligation. Substantially all of Ambac Credit Product’s credit derivative contracts relate to structured finance transactions. As part of its refocused business strategy, Ambac decided to discontinue the execution of credit enhancement transactions in credit default swap format. However, Ambac may execute restructuring or hedging transactions in derivative format for purposes of mitigating losses and/or improving our position relative to existing credit exposures. See “Quantitative and Qualitative Disclosures About Market Risk” located in Part II, Item 7A for further information about credit derivatives.

Through its financial services subsidiaries, Ambac provided financial and investment products including investment agreements, funding conduits, interest rate, currency and total return swaps, principally to the clients of its financial guarantee business. As part of its refocused business strategy, Ambac decided to discontinue writing new business in its Financial Services segment. The interest rate swap and investment agreement businesses are being run off. In the process of doing so, we expect to execute hedging transactions to mitigate

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risks in the respective books of business to the extent that we are able to do so; the ratings and financial condition of Ambac Assurance, which acts as credit support provider with respect to these subsidiaries, will make execution of any such hedging transactions more difficult. Such hedging transactions may include execution of swaps or other derivative instruments for the purpose of re-hedging risks inherent in the investment agreement business and the interest rate and currency swap business. Please see Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” for further discussion.

As a holding company, Ambac is largely dependent on dividends from Ambac Assurance to pay principal and interest on its indebtedness and to pay its operating expenses. Ambac Assurance is unable to pay dividends to Ambac in 2009 without the consent of the Office of the Commissioner of Insurance of the State of Wisconsin (“OCI”). Consequently, no guarantee can be given that Ambac Assurance will be able to dividend amounts sufficient to pay all of Ambac’s operating expenses and debt service obligations. See “Insurance Regulatory Matters—Wisconsin Dividend Restrictions” section and “Management’s Discussion and Analysis—Liquidity and Capital Resources” located in Part II, Item 7 for further information.

Financial information concerning our business segments for each of 2008, 2007 and 2006 is set forth in “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and the consolidated financial statements and the notes thereto, which are in Part II, Items 7, 7A and 8 of the Annual Report on Form 10-K. Our Internet address is www.ambac.com. We make available free of charge, on or through the investor relations section of our web site, annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as well as proxy statements, as soon as reasonably practicable after we electronically file such material with, or furnish it to, the U.S. Securities and Exchange Commission. Our Investor Relations Department can be contacted at Ambac Financial Group, Inc., One State Street Plaza, New York, New York 10004, Attn: Investor Relations, telephone: 212-208-3333.

Recent Developments:

During the first quarter of 2008, Ambac announced that it would discontinue writing new business in its Financial Services segment as part of its refocused business strategy. The interest rate swap and investment agreement businesses are in active runoff, which may include terminations, settlements, restructuring, assignments of and scheduled amortization of contracts. In the course of managing the inherent risks of these portfolios during runoff, the Financial Services segment may enter into new financial instrument transactions for hedging purposes to the extent we are able to do so.

In 2008, Ambac undertook a review of all its businesses in its Financial Guarantee segment. In conducting this review, Ambac considered the risk exposure within each business (including management’s view of the probability of default, the potential loss given default and the relevant correlations), the risk adjusted returns over the course of an economic cycle and Ambac’s franchise value and competitive advantages. As a result of this review, Ambac has decided to emphasize global public finance (including municipal finance, healthcare, infrastructure and global utilities) and re-evaluate and/or discontinue its participation in certain sectors of the structured finance market. Additionally, Ambac has revised its underwriting and risk management guidelines and determined to discontinue credit enhancement transactions in credit default swap or other derivative formats; however, we may execute restructuring or hedging transactions in derivative format for purposes of mitigating losses and/or improving our position relative to existing credit exposures.

In December 2008, Ambac also discontinued the quarterly dividend payable on our common shares.

Ambac is working to reduce risk and mitigate losses in its insured portfolio and is seeking to preserve and grow its business franchise. Efforts to preserve and grow our business franchise are currently focused primarily on the reactivation of our subsidiary, Connie Lee Insurance Company (which has been renamed Everspan Financial Guarantee Corp.) (“Everspan”), as described in more detail below. We are also exploring other

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initiatives including mortgage servicing and consulting businesses in various sectors of the credit markets. If we are unable to accomplish the reactivation of Everspan in a timely manner, Ambac Assurance will need to reduce its operating expenses. Our efforts to preserve and grow our business will then be primarily focused on initiatives outside the financial guarantee insurance industry; these initiatives will likely need to be financed by Ambac Financial Group, Inc.

The reactivation of Everspan would allow us to begin writing financial guarantee insurance in the U.S. public finance market as a separate, stand-alone legal entity. The management team of Everspan would be primarily assembled from within Ambac Assurance’s Public Finance division.

Receipt of financial strength ratings which are sufficiently high to enable Everspan to successfully market its financial guarantees is critical to Everspan’s business plan. To that end, we are engaged in discussions with Moody’s and S&P and are attempting to address their requirements. Foremost among these requirements is the infusion of third party capital, and we are actively seeking third party capital providers. We plan to finance our investment in Everspan by means of a capital contribution by Ambac Assurance. Any such contribution requires the approval of the OCI. The OCI is currently considering our request for approval of such a contribution. The OCI has indicated that it will not approve an investment in Everspan by Ambac Assurance unless Everspan receives financial strength ratings of at least “AA” from S&P and “A2” from Moody’s. Everspan’s success is dependent on the willingness of municipal issuers to use Everspan’s financial guarantees and the willingness of municipal bond investors to purchase such securities.

The downgrades in 2008 resulted in a significant amount of collateral being posted by Ambac’s investment agreement and derivatives businesses. To enable the non-insurance companies to meet the collateral posting obligations, Ambac Assurance petitioned the OCI to permit various liquidity enhancing activities between these entities and Ambac Assurance. On November 5, 2008, the OCI issued a “non-disapproval” letter with respect to the following transactions between these entities:

As described above, the financial strength rating downgrades have adversely impacted Ambac’s ability to generate new business and will impact Ambac’s future business, operations and financial results. Although Ambac is considering various strategic alternatives, there can be no assurance that any actions taken by Ambac will improve its current ratings, that further rating downgrades will not occur, or that Ambac will be able to recommence writing significant amounts of new financial guarantee business in the near term or at all.

BUSINESS SEGMENTS

The following paragraphs describe the business operations of Ambac and its subsidiaries for its two reportable segments: Financial Guarantee and Financial Services. Ambac’s activity in these segments has been curtailed significantly as a result of the downgrades of Ambac Assurance’s financial strength ratings by Moody’s and S&P and Ambac’s decisions to discontinue underwriting certain types of financial guarantee business and to

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discontinue writing financial services business. As such, the following descriptions of the Financial Guarantee and Financial Services segments relate to the existing portfolios in those segments. Our activities in those segments are focused on risk management, surveillance, risk reduction and loss mitigation. In addition, we are seeking to capitalize and reactivate Everspan and are evaluating other credit-related business initiatives and opportunities in which we could enhance and make use of our existing resources and skills.

Financial Guarantee Segment

Markets

The financial guarantee segment includes financial guarantee insurance and other credit enhancement products, such as credit derivatives. Financial guarantee insurance provides an unconditional and irrevocable guarantee that protects the holder of a fixed income obligation against non-payment of principal and interest when due. Essentially, Ambac Assurance and its subsidiaries make payments if the obligor responsible for making payments fails to do so. Ambac Assurance and its subsidiaries serve the global capital markets by providing financial guarantee insurance for public finance and structured finance obligations. Both issuers and investors can benefit from financial guarantee insurance. Issuers typically benefit when the insurance increases the credit rating quality of their obligations, which has the effect of lowering their cost of borrowing because the insurance premium is less than the value of the spread between the yield on the insured obligation (carrying the credit rating of the guarantor) and the yield of the uninsured obligation. Financial guarantee insurance has historically increased the marketability of obligations issued by infrequent or unknown issuers or in connection with complex financings. Investors have generally benefited from increased liquidity in the secondary market, reduced exposure to price volatility caused by changes in the credit quality of the underlying obligor, monitoring and remediation by Ambac on insured transactions and added protection against a potential loss in the event that the obligor defaults on its obligation. As a result of the actions by the rating agencies in 2008, obligations guaranteed by Ambac Assurance and other financial guarantors have experienced significantly greater price volatility and reduced liquidity, thereby significantly reducing the benefits noted above. At its current ratings level, Ambac Assurance and its subsidiaries do not reduce the total cost of borrowing for issuers, which has led to a lack of business production since November 2007. Additionally, concerns over Ambac Assurance’s financial condition have significantly reduced demand for its insured securities and, accordingly, many insured obligations are trading in the market based on the creditworthiness of the underlying obligor.

In certain floating rate insured transactions, the issuer or ultimate obligor of insured securities is party to an interest rate swap that hedges its risk to interest rates, effectively creating a synthetic fixed rate obligation. In such transactions, Ambac Assurance has, from time-to-time, insured the obligor’s payment obligations under the interest rate swap contract, including in some but not all cases the obligation to make a termination payment upon the occurrence of certain specified termination events. Refer to Liquidity and Capital Resources included in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” located in Part II, Item 7 for discussion of potential liquidity risks under these transactions.

Ambac Assurance and its subsidiaries also guarantee or provide credit protection on obligations already carrying insurance from other financial guarantors, with Ambac Assurance obligated to pay only upon a default by both the underlying obligor and the original financial guarantor. At December 31, 2008, Ambac provided credit protection for $1.4 billion outstanding par on these obligations, primarily through the issuance of credit derivatives. The weighted-average rating of these underlying obligations, excluding the guarantee from other financial guarantors, was BBB+ at December 31, 2008.

In addition to the guarantees on fixed income obligations described above, Ambac Assurance has underwritten transactions which expose the company to risks which may not be correlated to credit risk; for example, market risk, weather-related or other disasters, mortality or other property and casualty type risk characteristics. Ambac has underwritten such business primarily in relation to broad indices and reference pools which embody diverse risk characteristics.

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Ambac Assurance seeks to minimize the risk inherent in its financial guarantee portfolio by maintaining a diverse portfolio which spreads its risk across a number of criteria, including issue size, type of obligation, geographic area and obligor.

Ambac Assurance derives financial guarantee revenues from: (i) premiums earned from insurance contracts; (ii) net investment income; (iii) revenue from credit derivative transactions; (iv) net realized gains and losses from sales of investment securities; and (v) certain structuring and other fees. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations” located in Part II, Item 7 and Note 18 of Notes to Consolidated Financial Statements located in Part II, Item 8 for further information.

Pricing:

Ambac Assurance determines premium rates on the basis of the type of transaction and its assessment of the risk it is guaranteeing. Factors considered in pricing include underlying credit risk and ratings, term to maturity, structure of the issue, credit and market factors including security features and other credit enhancement features and competitive factors, including competition from other financial guarantee insurers. Additionally, the interest rate spread between insured and uninsured obligations with characteristics similar to those of the proposed issue is considered in the pricing process as well as the cost and the projected return to Ambac Assurance. Pricing for financial guarantees are received either upfront (typical of public finance obligations) or in installments from the cash flows generated by the underlying assets (typical of structured finance obligations). Despite writing no material new business, Ambac continues to collect premiums on its existing portfolio of structured finance guarantees that pay premiums periodically.

Financial guarantee products are sold in three principal markets: the U.S. public finance market, the U.S. structured finance and asset-backed market and the international finance market.

U. S. Public Finance Market

Due to market uncertainties as a result of Ambac being downgraded by Moody’s and S&P, Ambac’s origination volume in U.S. Public Finance is down significantly from prior years. Ambac is seeking to reenter the U.S. public finance market in 2009 via a separate capitalized and rated subsidiary, Everspan. Everspan’s business will be narrowly focused on municipal finance and other public purpose financings such as not-for-profit healthcare providers and utilities.

Ambac’s portfolio of U.S. Public Finance exposures is $238 billion, representing 55% of Ambac’s net par outstanding. This consists of U.S. municipal issuance including general obligations, lease and tax-backed obligations, health care, housing, public utilities, transportation and higher education, as well as certain infrastructure privatization transactions, such as toll road and bridge financings, public transportation financings, stadium financings, military housing and student housing. Public finance obligations are generally supported by either the taxing authority of the issuer or the issuer’s or underlying obligor’s ability to collect fees or assessments for certain projects or public services.

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The following table sets forth the volume of new issues of long-term (longer than 12 months) public finance bonds and the volume of new issues of insured long-term public finance bonds over the past ten years in the United States.

U.S. Public Finance Long-Term Market

Source: Amounts as reported by The Bond Buyer. Amounts represent gross par amounts issued or insured, respectively, during such year.

The decline in volume in 2008 reflected poor general market conditions and the inability of some issuers to access the market. The precipitous decline in insured volume reflected a lack of financial guarantee capacity following ratings downgrades of most financial guarantors. Refundings in 2008 were primarily driven by refinancing of auction rate securities and variable rate demand obligations. As a result of the current crisis, interest rates on these floating rate securities were increased significantly; and as a result, many issuers have refinanced these obligations by issuing fixed-rate obligations.

The table below shows our ten largest Public Finance exposures, by repayment source, as a percentage of total Financial Guarantee net par outstanding at December 31, 2008:

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U.S. Structured Finance and Asset-Backed Market

In 2008, the U.S. structured finance market experienced widespread illiquidity and lack of new issuance volume. When combined with the downgrades and uncertainty surrounding Ambac, the result was that no material new business was originated by Ambac in this sector. While Ambac and market participants expect the structured finance market to recover in time, the recovery process may be prolonged. Government involvement, including numerous programs designed to provide liquidity and funding to the sector, may speed the recovery but will likely change the nature of the business during 2009, adding to uncertainty regarding the market dynamics and demand characteristics of this sector. Depending on developments in this sector, and on Ambac Assurance’s capital position, Ambac anticipates that it may participate in the structured finance sector in the future.

Ambac’s portfolio of U.S. Structured Finance exposures is $140 billion, representing 32% of Ambac’s net par outstanding. Sectors covered include securitizations of mortgage loans, home equity loans, auto loans, student loans, credit card debt, leases, operating assets and CDOs where the majority of the underlying collateral risks are situated in the United States. Additionally, Ambac’s Structured Finance business encompasses both secured and unsecured debt issued by investor-owned utilities. Included within the operating asset sector are securitizations of aircraft, rental cars, shipping container and rail car fleets, as well as film rights, franchise fees, pharmaceutical royalties, and intellectual property.

Structured Finance includes credit enhancement for asset-backed commercial paper conduits (“conduits”). Conduits are used by issuers to efficiently fund assets in the commercial paper market. Typically sponsored by financial institutions, the conduits usually purchase financial assets and asset-backed securities, and issue commercial paper to fund the purchase of the assets. The typical conduit structure provides Ambac with significant credit protection prior to a claim on Ambac’s insurance policy. A conduit requires program-wide credit enhancement as one of several elements needed to support the conduit’s credit rating for the structure, Ambac insures a senior portion of the risk in the conduit, and is protected in part by this program-wide credit enhancement. As Ambac experienced downgrades to it ratings during 2008, certain conduit enhancement facilities provided by Ambac were cancelled by the conduits’ sponsors. Despite this, Ambac continues to provide ongoing conduit enhancement on a smaller scale to a limited number of conduits.

Structured Finance also includes the credit enhancement of CDOs. These transactions involve the securitization of a portfolio of corporate bonds, corporate loan obligations and/or asset-backed securities, including exposure to residential mortgages. Please refer to Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Residential Mortgage-Backed Securities Exposures” for further discussion.

Structured finance obligations generally entail three forms of risks: (i) asset risk, which relates to the amount and quality of the underlying assets; (ii) structural risk, which relates to the extent to which the transaction’s legal structure and credit support provides protection from loss; and (iii) servicer risk, which is the risk that poor performance at the servicer or manager level contributes to a decline in cash flow available to the transaction. Ambac Assurance addresses these risks through its credit underwriting guidelines, policies and procedures.

Structured securities are usually designed to help protect the investors and, therefore, the guarantor from the bankruptcy or insolvency of the entity that originated the underlying assets as well as from the bankruptcy or insolvency of the servicer of those assets. The servicer of the assets is typically responsible for collecting cash payments on the underlying assets and forwarding such payments, net of servicing fees, to a trustee for the

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benefit of the issuer. Other potential issues include whether the sale of the assets by the originator to the issuer would be upheld in the event of the bankruptcy or insolvency of the originator and whether the servicer of the assets may be permitted or stayed from remitting to investors cash collections held by it or received by it after the servicer or the originator becomes subject to bankruptcy or insolvency proceedings. Structural features of a transaction, such as control rights that are typically held by the senior note holders, will impact the extent to which underlying asset performance affects the performance of the guaranteed securities.

Ambac Assurance guaranteed gross par of $7.1 billion, $53.6 billion and $62.4 billion in 2008, 2007 and 2006, respectively, in the U.S. structured finance market. U.S. Structured Finance new business guaranteed represents 63%, 43% and 50% of total gross par guaranteed for 2008, 2007 and 2006, respectively. The Structured Finance business written in 2008 primarily relates to transactions to which Ambac had committed in prior years. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations” located in Part II, Item 7 for further discussion.

The table below shows our ten largest Structured Finance transactions, as a percentage of total financial guarantee net par outstanding at December 31, 2008:

International Finance Market

Outside of the United States, capital markets have experienced dislocation similar to that seen in the U.S., with sharply reduced origination volumes. As a result of this and the same factors impacting Public Finance and U.S. Structured Finance origination, Ambac wrote no material new business internationally in 2008.

Ambac’s portfolio of International exposures is $56 billion, representing 13% of Ambac’s net par outstanding. Ambac’s existing International Finance exposure includes a wide array of obligations in the

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international markets including infrastructure financings, asset-securitizations, CDOs, utility obligations, whole business securitizations (e.g. securitizations of substantially all of the operating assets of a corporation) and other obligations.

Ambac UK, which is authorized and regulated in the United Kingdom to provide certain classes of general financial guarantees (and is also authorized to conduct business throughout much of the European Union), has been Ambac Assurance’s primary vehicle for directly issuing financial guarantee policies in the United Kingdom and the European Union. In 2005, Ambac UK established a branch office in Milan, Italy. Ambac UK has entered into net worth maintenance and reinsurance agreements with Ambac Assurance pursuant to which Ambac Assurance provides capital support to Ambac UK.

In emerging markets Ambac has focused on future flow transactions from top tier issuers (structured transactions secured by U.S. Dollar and Euro cash flows generated from exports or payment remittances) and to a more limited extent, on domestic securitizations.

In 2008, Ambac Assurance terminated its alliance in Japan with Sompo Japan Insurance Inc. (“Sompo Japan”), as Sompo Japan announced it was exiting the financial guarantee business. Ambac will be closing its Tokyo office as of March 31, 2009.

Due to market uncertainties as a result of Ambac being downgraded by Moody’s and S&P, Ambac’s International Finance origination volume is down significantly from prior years. In the international markets, an understanding of the unique risks related to the particular country and region that could impact the credit of the issuer is necessary. These risks include legal and political environments, capital market dynamics, foreign exchange issues, and the degree of governmental support. Ambac Assurance monitors these risks carefully and addresses them through its credit underwriting guidelines, (which include country limits), underwriting procedures and transaction documentation.

Geographically, the international markets that Ambac Assurance focused on have been the United Kingdom, continental Europe, Australia, Japan and certain emerging market countries. In addition, Ambac Assurance has guaranteed transactions in which the geographic risk is spread over multiple countries.

Ambac Assurance guaranteed gross par of $2.6 billion, $20.1 billion and $19.0 billion in 2008, 2007 and 2006, respectively, in the international market. International Finance new business guaranteed represented 23%, 16% and 15% of total gross par guaranteed for 2008, 2007 and 2006, respectively. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations” located in Part II, Item 7 for further discussion.

The table below shows our ten largest International Finance transactions as a percentage of total financial guarantee net par outstanding at December 31, 2008:

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Risk Management

In 2008, Ambac announced that it had reorganized the risk management function. This reorganization included structural and process-related changes related to risk management at Ambac, with an increased emphasis on risk-adjusted returns for new business as well as increasing the firm-wide emphasis on risk reduction in the existing portfolio.

The worsening of the economic crisis throughout 2008 caused us to heighten our surveillance efforts on the insured portfolio, focusing on the identification of vulnerable credits and asset types across the portfolio. We increased staff in all surveillance areas to maintain an intensified emphasis on the oversight of vulnerable credits, and a continued focus on loss mitigation and aggressive remediation.

All risk management responsibilities are now consolidated under a Chief Risk Officer. The Chief Risk Officer is responsible for credit risk management; capital management and deployment; and surveillance and remediation of the existing insured portfolio. In the area of credit risk management, the Chief Risk Officer is charged with responsibility to review and strengthen underwriting policies and procedures, including identification of business sectors which will be emphasized, deemphasized or exited by Ambac. The Chief Risk Officer is also empowered to veto any transaction that has been approved by the relevant credit committee. However, the CEO may override the Chief Risk Officer’s veto, upon notice to the Chairman of the Audit and Risk Assessment Committee of Ambac’s Board of Directors. The Chief Risk Officer reports to the Board of Directors on a “dotted line” basis and will inform and update the Audit and Risk Management Committee of the Board of Directors with respect to risk-related topics. In the area of capital management and deployment, the Capital and Risk Analysis Group created in early 2008 has responsibility for transaction and portfolio based risk/return and capital analyses.

Ambac also has an Executive Risk Management Committee (“ERMC”) which employs various procedures and controls to monitor and manage risk. The ERMC is comprised of Ambac’s senior risk professionals and senior management. Its purview is enterprise-wide and its focus is on risk limits and measurement, concentration and correlation of risk and the attribution of economic and regulatory capital in a portfolio context.

Ambac has a Transaction Standards Committee which evaluates the suitability of transactions and new products for Ambac participation with particular emphasis on potential legal, accounting, regulatory and/or reputation risks.

Underwriting guidelines, policies and procedures have been developed by Ambac Assurance’s management with the intent that Ambac Assurance guarantees only those obligations which, in the opinion of Ambac Assurance underwriting officers, are of investment grade quality with a remote risk of loss. However, losses may occur and it is Ambac Assurance’s policy to provide for loss reserves on non-derivative insurance policies that are adequate to cover probable and estimable losses. For derivative insurance policies and credit derivatives, changes in fair value are reflected currently in net income. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Note 2 and Note 6 of Notes to Consolidated Financial Statements, located in Part II, Items 7 and 8, respectively, for further information.

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Underwriting at Everspan:

Going forward, the municipal finance underwriting process will be similar to but independent of Ambac Assurance. The underwriting process for each transaction will involve a review of structural, legal, political and credit issues, including compliance with Everspan underwriting policies. These policies will be reviewed periodically by Everspan management. Additionally, the underwriting process will often entail on-site due diligence covering the parties to the transaction.

The decision to guarantee an issue will be based upon such credit factors as the issuer’s ability to repay the bonds, the bond’s security features and structure, rather than using an actuarial method (typical of property & casualty and life insurers) to predict the likelihood that the issuer will default on the underlying debt obligation.

Members of Everspan’s underwriting staff will review all requests for guarantees. The underwriting process is designed to screen issues and begins with a credit analysis by the primary analyst assigned to the issue. The credit is then reviewed within the primary analyst’s underwriting group. At a minimum, the primary analyst’s recommendation to qualify or reject an issue must be approved by a concurring analyst and a credit officer. The number of additional approvals required for a particular credit will depend in part on Everspan’s aggregate exposure to the credit. In some cases, the complexity of the credit or whether it is a new asset type are determining factors in the approval/review process.

Everspan will assign internal ratings to individual exposures as part of the underwriting process and at surveillance reviews. These internal ratings, which will represent Everspan’s independent judgments, will be based upon underlying credit parameters.

Surveillance and Remediation:

The Portfolio Risk Management Group is responsible for monitoring outstanding financial guarantee exposures, including credit derivatives. The group’s monitoring activities are designed to detect deterioration in credit quality or changes in the economic, regulatory or political environment which could adversely impact the portfolio. Active surveillance enables Ambac Assurance’s Portfolio Risk Management Group to track single credit migration and industry credit trends. Surveillance analysts also monitor the financial guarantee portfolio for concentrations of risk by (i) specific bond types; (ii) geographic location; and (iii) size of issue.

Surveillance analysts review, on a regular and ad hoc basis, credits in the book of business. Risk-adjusted surveillance strategies have been developed for each transaction type. Review periods and scope of review vary by bond type based upon each bond type’s inherent risk profile. The risk profile is assessed regularly in response to our own experience and judgments or external factors such as the current market crisis.

The focus of the surveillance review is to assess performance, identify credit trends and recommend appropriate classifications, ratings and review periods. If a problem is detected, the group focuses on loss mitigation by recommending appropriate action and working with the issuer, trustee, bond counsel, servicer and other interested parties in an attempt to remediate the problem and minimize Ambac Assurance’s exposure to potential loss. In some cases, the Surveillance Group will engage attorneys and other outside consultants with appropriate expertise in the targeted loss mitigation strategy to assist management in examining the underlying contracts or collateral or providing industry specific advice. In structured transactions, Ambac often is the control party as a result of insuring the transaction’s senior class or tranche. The control party may direct specified parties, usually the trustee, to take or not take certain actions following contractual defaults or trigger events. Control rights and the scope of direction and remedies vary considerably among our insured transactions. Those credits that are either in default or have developed problems that eventually may lead to a default, claim or loss are tracked closely by the appropriate surveillance team and reported to management and in summary to Ambac’s Board of Directors by preparation of an adversely classified credit listing. Relevant information, along with the plan for corrective actions and a reassessment of the credit’s rating and credit classification, is reviewed with senior management in regular adversely classified credit meetings. Internal and/or external counsel generally reviews the documents underlying any problem credit and if applicable, an analysis is prepared

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outlining Ambac Assurance’s rights and potential remedies, the duties of all parties involved and recommendations for corrective actions. Ambac Assurance also meets with relevant parties to the transaction as necessary. In many instances, Ambac Assurance, under the terms of the documents governing the underlying obligation, has the ability, among other things, to direct that audits be performed with respect to servicer and trustee contractual responsibilities.

The rating agencies also review the credits underlying Ambac Assurance’s financial guarantees and, in most cases, advise Ambac Assurance of the credit rating each transaction would receive if it were not insured.

Surveillance for collateral dependent transactions focuses on review of the underlying assets’ value or cash flows and, if applicable, the performance of servicers or collateral managers. In connection with our financial guarantee, Ambac generally receives periodic reporting of transaction performance from issuers or trustees. Analysts review these reports to monitor performance and, if necessary, seek legal or accounting advice to assure reporting and application of cash flows comply with transaction requirements.

Ambac Assurance manages servicer risk for its structured finance exposures in several ways. In connection with the initial decision to guarantee, Ambac Assurance analyzes the capitalization and credit quality, the experience and financial strength of the servicer of the underlying assets. Thereafter, Ambac Assurance monitors the performance of transaction servicers through a combination of (i) on-site servicer reviews; (ii) compliance certificates received from servicer management; (iii) independent rating agency information; and (iv) a review of servicer financial information. On-site servicer reviews typically include a review of the collection, default management and quality control processes. Where appropriate, a third-party, such as an independent audit firm, may perform the review. In addition, Ambac Assurance may require a back-up servicer or require “term-to-term” servicing which provides for limited, renewable servicing terms in order to provide greater flexibility regarding the servicing arrangements of a particular transaction.

A significant portion of Ambac Assurance’s structured finance exposures relates to the mortgage-backed and home equity loan market. The issuers typically originate or purchase residential mortgages, home equity loans or home equity lines of credit, which are in turn bundled into pools which are sold by the issuers in the form of asset-backed securities. The servicer administers the underlying loans in the pools and may or may not be affiliated with the loans’ originators or the issuer.

The following table presents the top five servicers by net par outstanding, for global structured finance exposures:

Financial Guarantees in Force

Ambac Assurance has underwritten and priced financial guarantees on the assumption that the guarantee will remain in force until expected maturity of the underlying bonds. Ambac Assurance estimated that the average life of its guarantees on par in force at December 31, 2008 is 14 years. The 14 year average life is determined by applying a weighted average calculation, using the remaining years to expected maturity of each guaranteed bond, and weighting them on the basis of the remaining net par guaranteed. No assumptions are made for future refundings of guaranteed issues.

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Ambac Assurance’s portfolio represents a diversified portfolio of risk based on a variety of criteria, including issue size, type of bond, geographic area and issuer.

As of December 31, 2008, the total net par amount of guaranteed bonds outstanding was $434.3 billion. See Note 15 of Notes to Consolidated Financial Statements, located in Part II, Item 8 for further information.

Types of Bonds

The table below shows the distribution by bond type of Ambac Assurance’s guaranteed portfolio as of December 31, 2008.

Guaranteed Portfolio by Bond Type

as of December 31, 2008⁽¹⁾⁽²⁾

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Ambac’s total outstanding asset-backed and conduit exposures within both structured finance and international finance are comprised of the following bond types as of December 31, 2008 and December 31, 2007:

The following tables provide a rating distribution of guaranteed total net par outstanding based upon internal Ambac Assurance credit ratings at December 31, 2008 and December 31, 2007 and a distribution by bond type of Ambac Assurance’s below investment grade exposures at December 31, 2008 and December 31, 2007. Below investment grade is defined as those exposures with a credit rating below BBB-:

The decline in AAA related primarily to deterioration of CDO of ABS > 25% RMBS transactions, which were mostly downgraded from AAA to BIG during 2008.

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Summary of Below Investment Grade Exposure⁽¹⁾

The increase in mortgage-backed and home equity is the result of continued credit impairment, primarily in the mid-prime first-lien and all second-lien credits. The increase in CDO of ABS greater than 25% RMBS resulted from the continued credit deterioration of RMBS and CDO collateral within the high-grade CDO of ABS transactions. Mezzanine CDO of ABS which comprised most of the CDO of ABS greater than 25% RMBS at December 31, 2007 were commuted during 2008. Please refer to the Residential Mortgage-Backed Securities exposure included in the Management’s Discussion and Analysis of Financial Condition and Results of Operations in Part II, Item 7.

Auction Rate Securities and Variable Rate Demand Obligations:

Fixed income securities issued in the US bond market include fixed and variable rate bonds. Included within the variable rate bond category are Auction Rate Securities (“ARS”) and Variable Rate Demand Obligations (“VRDO”).

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The following table displays Ambac Assurance’s financial guarantee net par exposure outstanding, by bond type, relating to such variable rate securities at December 31, 2008:

ARS are sold through a Dutch Auction, which is a competitive bidding process used to determine rates on each auction date. Bids are submitted to the auction agent. The winning bid rate is the rate at which the auction “clears”, meaning the lowest possible interest rate that results in the cumulative total of securities demanded at such rate (“buyers”) equaling the amount auctioned (“sellers”). VRDO are long-term bonds that bear a floating interest rate and that provide investors the option to tender or put securities back to the issuer at any time with appropriate notice. Additionally, there are certain mandatory events that require all bondholders to tender their VRDO to the issuer. Upon tender, bondholders are paid a purchase price, equal to the par amount of the tendered VRDO plus accrued interest, typically paid from the proceeds of a remarketing of the tendered VRDO by a remarketing agent. The interest rate resets daily or weekly, depending upon the security. The reset rate is based on comparable securities with similar maturities and credit ratings, as well as on supply and demand.

VRDO are typically supported by a liquidity facility in the form of a standby bond purchase agreement (“Standby Bond Purchase Agreement”), usually provided by a commercial bank (“Liquidity Provider”). If the remarketing agent is unable to remarket all tendered VRDO, the Liquidity Provider is required to purchase such VRDO at the purchase price, subject to limited conditions precedent, thus providing liquidity to investors. While held by the Liquidity Provider, the VRDO bear interest at a rate determined under the Standby Bond Purchase Agreement, often based on the Prime Rate plus a spread (the “Bank Rate”). During such time, the remarketing agent remains obligated to continue to try to remarket the VRDO held by the Liquidity Provider. Many Standby Bond Purchase Agreements provide that, after the Liquidity Provider has held the VRDO for a specified time period, the issuer or other obligor is required to cause such VRDO to be redeemed prior to maturity, either: in equal periodic installments over a predetermined number of years, typically from three to five (“Term-Out”), or in a single lump sum at the end of three to five years. Other Standby Bond Purchase Agreements do not contain a Term-Out. For VRDO insured by Ambac Assurance, Ambac Assurance has typically endorsed its insurance policy to cover interest at the Bank Rate. For VRDO insured by Ambac Assurance that contain a Term-Out, Ambac has often endorsed its insurance policy to cover the required redemptions in accordance with the Term-Out schedule (though not any acceleration of the VRDO maturity ahead of the Term-Out schedule).

For student loan VRDO transactions, Ambac Assurance is required to purchase the VRDOs from the remarketing agent at par, in the event that the remarketing agent is not able to resell the bonds to the marketplace after holding the bonds for approximately five years, introducing liquidity risk to Ambac Assurance.

As a result of the current credit crisis, the demand for purchase of ARS securities has been significantly reduced as investors have avoided these securities for fear of losing liquidity in the marketplace. Accordingly, fewer or no participants attend these auctions, resulting in the sellers being required to continue to hold the securities and often significantly increasing the interest rates on the ARS. Additionally, a number of Ambac Assurance’s insured VRDO have been purchased by the Liquidity Providers or have otherwise had higher

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interest rate resets. Issuers have been working towards reducing their debt service costs for ARS and VRDO transactions; the most prevalent ways are (i) converting the bonds to fixed rate (to maturity or for a shorter period of time); (ii) refunding the obligation and issuing fixed rate bonds; (iii) purchasing direct-pay letters of credits from other financial institutions; or (iv) amending their liquidity facilities to address investor liquidity concerns. For these reasons, Ambac’s exposure to ARS and VRDO transactions have declined by 46% since March 31, 2008.

For Ambac Assurance insured ARS and VRDO transactions that have been unable to refinance, the higher debt service costs have resulted in decreased debt service ratios and/or the erosion of first loss and/or other credit enhancements that are subordinate to Ambac Assurance’s risk position (such as excess spread in student loan transactions). Through December 31, 2008, Ambac Assurance has not paid any claims on these transactions but due to the impact of higher interest rates has established loss reserves of approximately $49 million for certain ARS and VRDO transactions, primarily VRDO student loan transactions. Ambac continues to actively review the credit implications of this additional issuer stress and its impact to our internal credit ratings and loss reserves as necessary.

Issue Size

Ambac Assurance seeks a broad coverage of the market by guaranteeing small and large issues alike. Ambac Assurance’s financial guarantee exposure in the U.S. public finance market reflects the historical emphasis on issues guaranteed with an original par amount of less than $50 million. However, U.S. structured finance and international finance transactions generally involve larger deals. The following table sets forth the distribution of Ambac Assurance’s guaranteed portfolio as of December 31, 2008, with respect to the original size of each guaranteed issue:

Par Amount Per Issue

as of December 31, 2008

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Geographic Area

Ambac Assurance and its subsidiary, Ambac UK, are licensed to write business in the U.S. and abroad. The following table sets forth the geographic distribution of Ambac Assurance’s insured exposure as of December 31, 2008:

Mortgage and asset-backed obligations include guarantees with multiple locations of risk within the United States. Internationally diversified is primarily made up of CDOs which include significant components of U.S. exposure.

The table below shows the distribution by currency of Ambac Assurance’s guaranteed portfolio as of December 31, 2008:

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Single Risk

Ambac Assurance has adopted underwriting and exposure management policies designed to limit the net guarantees in force for any one credit. In addition, Ambac Assurance uses reinsurance to limit net exposure to any one credit. The highest single insured risk represented 0.7% of the aggregate net par outstanding at December 31, 2008. See “Insurance Regulatory Matters” and “Rating Agencies” for a more detailed discussion. Everspan will have its own single risk limits which will be sized appropriately for its capital base.

Competition

Due to the downgrades of Ambac Assurance’s financial strength ratings and investor concerns with respect to its financial condition, Ambac Assurance and Ambac UK have been able to originate only a de minimis amount of new financial guarantee business since November 2007. As described in “Recent Developments”, Ambac Assurance is seeking to capitalize and reactivate Everspan to write new financial guarantee business in the U.S. public finance and regulated utility markets. To the extent that either Ambac Assurance, Ambac UK or Everspan is able to become active in the capital markets, it will operate in a competitive environment.

Historically, the financial guarantee business has been highly competitive. Ambac Assurance faces competition from other financial guarantors and alternative forms of credit enhancement. Accordingly, each transaction that Ambac Assurance, Ambac UK or Everspan proposes to guarantee may compete against an alternative execution, e.g. credit derivatives, letters of credit or structures that do not employ third-party credit enhancement, including senior/subordinated structures. Financial guarantee insurance and other forms of credit enhancement also compete in nearly all instances with the issuer’s alternative of foregoing credit enhancement and paying a higher interest rate. If the interest savings from insurance or another form of credit enhancement are not greater than the cost of such credit enhancement, the issuer is usually unwilling to accept the insurer’s terms and conditions for insurance or does not perceive the insurer to have sufficient financial strength, the issuer will generally choose to issue bonds without credit enhancement. Credit spreads are a significant factor in the issuer’s determination of whether or not to seek credit enhancement. Credit spreads represent the difference in interest cost for issuers between their projected or actual borrowing rate compared to a benchmark rate (such as U.S. Treasuries). As an issuer’s credit rating rises or as credit spreads become compressed (e.g. due to increased amounts of investment capital in the markets), the likelihood that the issuer will choose to issue bonds without credit enhancement increases.

In recent years, the overall business environment became more competitive, with increased competition from bank funding, the uninsured market, senior/subordinated securitizations and other triple-A-rated financial guarantors. And during 2008, the use of letters of credit in the U.S. municipal market increased substantially. Historically, Ambac Assurance and Ambac UK’s principal competitors in the financial guarantee industry have been MBIA Insurance Corporation (“MBIA”), Financial Guaranty Insurance Company (“FGIC”), Financial Security Assurance Inc. (“FSA Guarantee”) and Assured Guaranty Corp. (“Assured Guaranty”). More recently, however, as a result of the stressed credit environment the capital markets have been experiencing since 2007, the competitive landscape in the financial guaranty industry has changed significantly. A number of companies have (i) been downgraded by one or more rating agencies resulting in most financial guarantors losing their Triple-A ratings, some being downgraded to below investment grade or ratings withdrawn; (ii) ceased writing structured finance transactions; (iii) exited the financial guarantee business entirely; (iv) ceded a significant portion of their insured portfolios; (v) announced acquisitions or restructuring plans and/or (v) experienced significant losses. Some of the recent changes among financial guarantor companies in 2008 and the beginning of 2009 include: (i) Assured Guaranty’s announcement of its intention to acquire FSA Guarantee (ii) Assured Guaranty’s reinsurance assumption of CIFG Assurance North America, Inc. U.S. Public Finance insured portfolio; (iii) MBIA’s reinsurance assumption of FGIC’s U.S. Public Finance insured portfolio; (iv) MBIA’s announcement that it has established a new U.S. public finance guarantee company (MBIA Insurance Corp. of Illinois; expected to be renamed National Public Finance Guarantee Corporation) by restructuring its principal insurance subsidiary, MBIA Insurance Corporation; (v) Berkshire Hathaway entering into the financial guarantee

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business in the first quarter of 2008, and (vi) potential establishment of Municipal and Infrastructure Assurance Corp. In addition, there have been recent discussions about a potential national insurer of municipal bonds. These events have resulted in much uncertainty in the financial guarantee markets and lower insured penetration rates.

The principal competitive factors among the financial guarantors are: (i) premium rates; (ii) conditions precedent to the issuance of a policy related to the structure and security features of a proposed bond issue; (iii) ratings, financial strength and perception of financial strength of the guarantor; (iv) the quality of service provided to issuers, investors and other clients of the issuer; (v) trading value of the financial guarantor’s insured obligations. As explained above, as a result of the recent actions the rating agencies have taken with respect to Ambac Assurance and other recent events, Ambac Assurance has been placed at a significant disadvantage regarding its ratings and perceived financial strength and trading value as a guarantor versus two of its principal competitors, FSA Guarantee and Assured Guaranty. With respect to the other competitive factors, Ambac Assurance believes it is on at least equal footing with each of its principal competitors.

In order to enter the financial guarantee market certain requirements must be met, most restrictive of which is that a significant minimum amount of capital is required of a financial guarantor in order to obtain appropriate financial strength ratings by the rating agencies. These capital requirements may deter other companies from entering the market. However, there can be no assurance that these capital requirements will deter potential competitors from entering the business. In addition to sufficient capital, the rating agencies have increasingly focused on the viability of the business model of potential entrants. Under New York law, a monoline financial guarantee insurer must have at least $75 million of paid-in capital and surplus and maintain thereafter at least $65 million of policyholders’ surplus. A similar law in California imposes a $100 million minimum capital and surplus requirement, with a maintenance requirement thereafter of $75 million.

Ambac also faces intense competition in attracting and retaining qualified employees. Ambac’s ability to compete effectively will depend upon the ability to attract employees and retain and motivate existing employees.

Reinsurance

Ceded Reinsurance:

State insurance laws and regulations as well as the independent rating agencies which rate Ambac Assurance impose minimum capital requirements on financial guarantee companies, limiting the aggregate amount of insurance and the maximum size of any single risk exposure which may be written. Ambac Assurance has used reinsurance to diversify risk, increase underwriting capacity, manage capital needs and strengthen financial ratios. Ambac Assurance has reinsurance in place pursuant to treaty and facultative reinsurance agreements which allow Ambac Assurance to reduce its large risks, to manage its portfolio of insurance by bond type and geographic distribution, and to provide additional capacity for frequent bond issuers. Ambac Assurance’s surplus share reinsurance treaty expired June 30, 2008 and has not been renewed. The availability of facultative reinsurance in the current market is severely limited. For exposures reinsured, Ambac Assurance withholds a ceding commission to defray its underwriting and operating expenses.

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The following table shows the distribution by bond type of Ambac Assurance’s ceded guaranteed portfolio at December 31, 2008:

Ceded Guaranteed Portfolio by Bond Type

as of December 31, 2008

As a primary financial guarantor, Ambac Assurance is required to honor its obligations to its policyholders whether or not its reinsurers perform their obligations under the various reinsurance agreements with Ambac Assurance. To minimize its exposure to significant losses from reinsurer insolvencies, Ambac Assurance (i) monitors the financial condition of its reinsurers, (ii) is entitled to receive collateral from its reinsurance counterparty in certain reinsurance contracts, and (iii) has certain cancellation rights that can be exercised by Ambac Assurance in the event of a rating downgrade by S&P or Moody’s of a reinsurer. Given the financial strength of its reinsurers at the inception of each reinsurance contract, Ambac Assurance requires collateral from reinsurers primarily to (i) receive statutory credit for the reinsurance for foreign reinsurers, (ii) provide liquidity

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to Ambac Assurance in the event of claims on the reinsured exposures and (iii) enhance rating agency credit for the reinsurance. Ambac Assurance held letters of credit and collateral amounting to approximately $627.2 million from its reinsurers at December 31, 2008. Refer to Item 7A – Risk Management for further discussion on insured par ceded and credit ratings of our reinsurance counterparties.

The current stressed credit environment has had and may continue to have an adverse impact on the financial strength of most of the reinsurers previously used by Ambac. Additionally, if the financial strength of these reinsurers further declines, it could impair Ambac Assurance’s ability to recover amounts due from such reinsurers.

Assumed Reinsurance:

Under reciprocal reinsurance agreements with various financial guarantor competitors, Ambac Assurance has assumed exposures. Ambac and MBIA have had such a reciprocal reinsurance agreement since 1995 when the two companies created an unincorporated international joint venture. In 2004, Ambac Assurance entered into reciprocal reinsurance agreements with FSA Guarantee for healthcare and international PFI transactions. Additionally, Ambac Assurance’s portfolio has assumed transactions that it obtained in connection with its purchase of Everspan in 1998. Under the provisions of each of these reinsurance agreements, the ceding company has certain cancellation rights that became exercisable upon the ratings downgrade of Ambac Assurance in 2008 and accordingly the ceding insurer has the ability to terminate and recapture the reinsured exposures. The cost of such termination is based on the provisions of each reinsurance contract and amounts may be higher than the amount of liabilities (loss reserves and unearned premium reserves) included in the financial statements. Certain contracts require an increase in ceding commission if termination is not elected by the primary insurer.

The following table displays assumed exposures by ceding enterprise as of December 31, 2008:

Rating Agencies

Moody’s and S&P periodically review Ambac Assurance’s business and financial condition, focusing on the quality of the obligations insured, financial performance metrics, and business and strategic plans. The rating agencies perform periodic assessments of the credits insured by Ambac Assurance, as well as the reinsurers and other providers of capital support, to confirm that Ambac Assurance continues to satisfy such rating agency’s capital adequacy criteria necessary to maintain Ambac Assurance’s current ratings.

Financial and other factors considered by the rating agencies in assessing Ambac Assurance’s ratings include:

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In the fall of 2007, each of the major rating agencies began a review of the capital adequacy of the financial guarantee industry. In late December 2007, following the rating agency reviews, Ambac’s triple-A rating was affirmed by both S&P (with “negative outlook”) and Moody’s. On January 16, 2008, Moody’s put Ambac Assurance’s Aaa rating on review for possible downgrade. On January 18, 2008, Fitch downgraded Ambac Assurance’s insurance financial strength rating to AA, Rating Watch Negative. In addition, on January 18, 2008, S&P put Ambac Assurance’s AAA rating on Credit Watch Negative. On February 25, 2008, S&P reaffirmed Ambac Assurance’s AAA rating, but kept it on Credit Watch Negative. On March 12, 2008 Fitch affirmed Ambac Assurance’s AA rating, and placed it on negative outlook. On March 12, 2008, Moody’s and S&P reaffirmed Ambac Assurance’s triple-A ratings with a negative outlook. On April 24, 2008, Moody’s reaffirmed Ambac Assurance’s triple-A rating with a negative outlook) after Ambac announced its first quarter earnings. On June 5, 2008, S&P downgraded Ambac Assurance’s financial strength rating to AA and placed it on Credit Watch Negative and on June 19, 2008, Moody’s downgraded it to Aa3 with negative outlook. On June 18, 2008 we requested Fitch withdraw their ratings, which they subsequently did on June 26, 2008. On August 14, 2008, S&P reaffirmed Ambac Assurance’s AA rating, removed it from Credit Watch Negative and placed it on negative outlook. On September 18, 2008, Moody’s announced that it was placing the ratings of Ambac Assurance and its subsidiaries on review for possible downgrade. On November 5, 2008, Moody’s downgraded Ambac Assurance’s financial strength rating to Baa1 with developing outlook and, on March 4, 2009, placed us on review for possible downgrade. Moody’s stated that, should Ambac Assurance’s regulatory capital position continue to deteriorate, there would be further negative pressure on Ambac Assurance’s ratings. On November 19, 2008 S&P lowered its rating on Ambac Assurance to A with a negative outlook.

The long-term senior unsecured debt of Ambac is rated BBB negative outlook by S&P and Ba1 on review for possible downgrade by Moody’s.

As a result of the rating agency actions described above, as well as significant disruption in the capital markets and investor concern with respect to our financial position, we have been able to originate only a de minimis amount of new financial guarantee business since November 2007. In light of the ongoing nature of ratings actions or announcements by the rating agencies, one should consult announcements by the rating agencies, the websites of the rating agencies and Ambac’s website for the then current publicly available information.

Insurance Regulatory Matters

United States of America

Ambac Assurance and Everspan are domiciled in the State of Wisconsin and, as such, are subject to the insurance laws and regulations of the State of Wisconsin (the “Wisconsin Insurance Laws”) and are regulated by the OCI. In addition, Ambac Assurance is licensed to transact financial guarantee and surety business as an insurance company in all other states, the District of Columbia, the Commonwealth of Puerto Rico, the territory of Guam and the U.S. Virgin Islands and is therefore subject to the insurance laws and regulations of those jurisdictions. Everspan maintains active licenses to write financial guarantees in the District of Columbia, the Commonwealth of Puerto Rico and all but three U.S. states.

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Insurance laws and regulations, as well as the level of supervisory authority that may be exercised by the various state insurance departments, vary by jurisdiction. The laws and regulations generally require financial guarantors to maintain minimum standards of business conduct and solvency; to meet certain financial tests; and to file policy forms, premium rate schedules and certain reports with regulatory authorities, including information concerning capital structure, ownership and financial condition. The laws and regulations also require prior approval of certain changes in control of domestic financial guarantors and their direct and indirect parents and prescribe permitted investments and limits applicable thereto. Regulated insurance companies are also required to file quarterly and annual statutory financial statements with the National Association of Insurance Commissioners (“NAIC”), and in each jurisdiction in which they are licensed.

Wisconsin Insurance Laws require regulated insurance companies to maintain minimum standards of business conduct, minimum surplus to policyholders and solvency. Additionally, the Wisconsin Insurance Laws require OCI approval with respect to specified transactions between regulated insurance companies (i.e. Ambac Assurance and Everspan) and other entities in the Ambac group, including, without limitation, capital contributions, loans, guarantees, reinsurance agreements, service agreements and payments of distributions and extraordinary dividends. Such affiliate transactions must be fair to the insurance company and must have terms similar to the terms that would result from arms-length negotiations. Additionally, the accounts and operations of Ambac Assurance and Everspan are subject to a comprehensive examination by the OCI every three to five years. See Note 17 of Notes to Consolidated Financial Statements located in Part II, Item 8 for further information.

United Kingdom

Ambac UK is licensed to transact credit, suretyship and financial guarantee insurance in the United Kingdom and to offer those services in a number of other European Union (“EU”) countries. EU legislation allows Ambac UK to conduct business pursuant to its license in EU states other than the United Kingdom through a “passporting” arrangement, which eliminates the necessity of additional licensing or authorization in those other EU jurisdictions.

Ambac Credit Products Limited, also an Ambac Assurance wholly-owned subsidiary, is licensed in the United Kingdom to transact credit derivatives, as well as act as agent for Ambac Credit Products and Ambac Capital Funding. Ambac Credit Products Limited is currently able to offer services via EU “passporting” in a number of other EU countries. We intend to close Ambac Credit Products Limited in 2009.

Ambac UK and Ambac Credit Products Limited are each subject to regulation by the Financial Services Authority (“FSA”) in the conduct of their business. The FSA is the single statutory regulator responsible for regulating the financial services industry in the U.K., having the authority to oversee the carrying on of “regulated activities” (including deposit taking, insurance and reinsurance, investment management and most other financial services), with the purpose of maintaining confidence in the U.K. financial system, providing public understanding of the system, securing the proper degree of protection for consumers and helping to reduce financial crime. In addition, the regulatory regime in the United Kingdom must comply with certain EU legislation binding on all EU member states.

The FSA requires that non-life insurance companies such as Ambac UK maintain a margin of solvency at all times in respect of the liabilities of the insurance company, the calculation of which depends on the type and amount of insurance business a company writes. In addition, the FSA has established a capital monitoring level for Ambac UK. Breach of the monitoring level requires that Ambac UK inform the FSA and enter into discussions as to the reasons for the breach, and ultimately with a view to a remedy that could include additional capital being required. The monitoring level is an interim arrangement, while the FSA reflects on alternative methodologies for a permanent basis for calculating regulatory capital in respect of Ambac UK and other financial guarantors regulated by the FSA. In addition, an insurer is required to perform and submit to the FSA a solvency margin calculation return in respect of its ultimate parent. These solvency requirements may need to be

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amended in order to implement the European Union’s proposed “Solvency II” directive on risk-based capital, but that is not expected to be implemented until 2012. Ambac believes that Ambac Assurance and Ambac UK are in compliance with all applicable insurance laws and regulations. However, FSA scrutiny of Ambac UK and the financial guarantee insurance industry is heightened and additional regulatory requirements may be imposed at any time.

Insurance Holding Company Laws

Under Wisconsin law applicable to insurance holding companies, any acquisition of control of Ambac, and as a result indirect control of Ambac Assurance and Everspan, requires the prior approval of the OCI. “Control” is defined as the direct or indirect power to direct or cause the direction of the management and policies of a person. Any purchaser of 10% or more of the outstanding voting stock of a corporation is presumed to have acquired control of that corporation and its subsidiaries unless the OCI, upon application, determines otherwise. For purposes of this test, Ambac believes that a holder of common stock having the right to cast 10% of the votes which may be cast by the holders of all shares of common stock of Ambac would be deemed to have control of Ambac Assurance and Everspan within the meaning of the Wisconsin Insurance Laws. The United Kingdom has similar requirements applicable in respect of Ambac, as the ultimate holding company of Ambac UK.

At various times, investors have sought and obtained OCI’s approval to acquire greater than 10% of Ambac’s outstanding stock. As a condition to obtaining approval without undergoing a comprehensive “change of control” review process, those investors disclaimed any present intention to exercise control over Ambac, Ambac Assurance or Everspan or to control or attempt to control the management or operations of Ambac, Ambac Assurance or Everspan.

Dividend Restrictions

Wisconsin:

Pursuant to the Wisconsin Insurance Laws, Ambac Assurance and Everspan may declare dividends, subject to restrictions in its articles of incorporation, provided that, after giving effect to the distribution, it would not violate certain statutory equity, solvency, income and asset tests. Distributions to Ambac (other than stock dividends) must be reported to the OCI. Additionally, no quarterly dividend may exceed the dividend paid in the corresponding quarter of the preceding year by more than 15% without notifying the OCI 30 days in advance of payment. Extraordinary dividends must be reported prior to payment and are subject to disapproval by the OCI. An extraordinary dividend is defined as a dividend or distribution, the fair market value of which, together with all dividends from the preceding 12 months, exceeds the lesser of: (a) 10% of policyholders’ surplus as of the preceding December 31 or (b) the greater of: (i) statutory net income for the calendar year preceding the date of the dividend or distribution, minus realized capital gains for that calendar year; or (ii) the aggregate of statutory net income for the three calendar years preceding the date of the dividend or distribution, minus realized capital gains for those calendar years and minus dividends paid or credited and distributions made within the first two of the preceding three calendar years. Due to losses experienced by Ambac Assurance in 2008, Ambac Assurance is unable to pay dividends to Ambac in 2009 without the prior consent of the OCI.

During 2008, 2007 and 2006, Ambac Assurance paid to Ambac cash dividends on its common stock totaling $218.5 million, $190.2 million and $136.0 million, respectively. See Note 17 of Notes to Consolidated Financial Statements located in Part II, Item 8 for further information.

United Kingdom:

UK law prohibits Ambac UK from declaring a dividend to its shareholders unless it has “profits available for distribution.” The determination of whether a company has profits available for distribution is based on its accumulated realized profits less its accumulated realized losses. While the UK insurance regulatory laws impose no statutory restrictions on a general insurer’s ability to declare a dividend, the FSA’s capital requirements may in practice act as a restriction on dividends.

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Statutory Contingency Reserve

Ambac Assurance is required to establish a mandatory contingency reserve in accordance with the NAIC Accounting Practices and Procedures manual (“NAIC SAP”) and the Wisconsin Administrative Code. The mandatory contingency reserve is an additional liability established to protect policyholders against the effect of adverse economic developments or cycles or other unforeseen circumstances. Under NAIC SAP, financial guarantors are required to establish a contingency reserve equal to the greater of 50% of premiums written or a stated percentage of the principal guaranteed depending on the category of obligation insured. However, under the Wisconsin Administrative Code, a municipal bond insurer is required to establish a contingency reserve consisting of 50% of earned premiums on policies of municipal bond insurance. The only exemption is when another jurisdiction in which the insurer is licensed requires a larger contingency reserve than required by the Wisconsin Administrative Code. Ambac Assurance calculates contributions using both methodologies and records the higher contribution amount. NAIC SAP contributions are required to be made in equal quarterly installments over a period of 20 years for municipal bonds and 15 years for all other obligations. Such contributions may be discontinued if the total reserve established for all categories exceeds the sum of the stated percentages contained therein multiplied by the unpaid principal balance. This reserve must be maintained for the periods specified above, except that the guarantor may be permitted to release reserves under specified circumstances in the event that actual loss experience exceeds certain thresholds or if the reserve accumulated is deemed excessive in relation to the guarantor’s outstanding guaranteed obligations, with notice to or approval by the insurance commissioner. As a result of the significant losses experienced by Ambac Assurance, the OCI approved the release of approximately $1.5 billion of contingency reserves in 2008.

New York Financial Guarantee Insurance Law

New York’s comprehensive financial guarantee insurance law defines the scope of permitted financial guarantee insurance and governs the conduct of business of all financial guarantors licensed to do business in New York, including Ambac Assurance. Financial guarantors are also required to maintain case basis credit loss and loss expense reserves and unearned premium reserves on a basis established by the statute.

The New York financial guarantee insurance law establishes single risk limits with respect to obligations insured by financial guarantee insurers. Such limits are specific to the type of insured obligation (for example, municipal or asset-backed). The limits generally compare the insured principal amount outstanding and/or average annual debt service on the insured obligations, net of reinsurance and collateral, for a single risk to the insurer’s qualified statutory capital, which is defined as the sum of the insurer’s policyholders’ surplus and contingency reserves. As a result of (i) decreased statutory capital resulting from the significant losses experienced by Ambac Assurance during 2008 and (ii) terminations of reinsurance arrangements and related buy-backs of previously reinsured exposures, Ambac’s net insured exposure under certain individual policies exceeded the applicable single risk limits prescribed by New York State Insurance Law. As required by New York State Insurance Law, Ambac Assurance intends to submit a plan to the Superintendent of the New York State Insurance Department detailing the steps that Ambac Assurance has taken and will seek to take to reduce its exposure to no more than the permitted amounts. Following the submission of such plan, after notice and hearing, the Superintendent could require Ambac Assurance to cease transacting any new financial guarantee business until its exposure to loss no longer exceeds said limits.

Aggregate risk limits are also established on the basis of aggregate net liability and policyholders’ surplus requirements. “Aggregate net liability” is defined as the aggregate of the outstanding insured principal, interest and other payments of guaranteed obligations, net of reinsurance and collateral. Under these limits, policyholders’ surplus and contingency reserves must at least equal a percentage of aggregate net liability that is equal to the sum of various percentages of aggregate net liability for various categories of specified obligations. The percentage varies from 0.33% for municipal bonds to 4.00% for certain non-investment grade obligations. As of December 31, 2008 and 2007, Ambac Assurance and its subsidiaries were in compliance with these regulatory requirements.

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Financial Guarantee Insurance Regulation in Other States

Wisconsin laws and regulations governing municipal bond guarantors are less comprehensive than New York law and relate primarily to municipal bond insurance business. The Wisconsin regulations include certain single and aggregate risk limitations. The average annual debt service for any single issue of municipal bonds may not exceed 10% of the sum of Ambac Assurance’s policyholders’ surplus and contingency reserves. In addition, Ambac Assurance’s cumulative net liability, defined as one-third of one percent of the guaranteed unpaid principal and interest covered by current municipal bond insurance policies, may not exceed its qualified statutory capital. As of December 31, 2008 Ambac Assurance and its subsidiaries were in compliance with these regulatory requirements.

California has financial guarantee insurance laws similar in structure to those of New York. None of the risk limits established in California’s legislation with respect to business transacted by Ambac Assurance are more stringent in any material respect than the corresponding provisions in the New York financial guarantee insurance statute.

In addition to the laws and regulations of New York, Wisconsin and California, Ambac Assurance is subject to laws and regulations of other states concerning the transaction of financial guarantees, none of which is more stringent in any material respect than the New York financial guarantee insurance statute.

Financial Services Segment

Ambac’s Financial Services segment has provided financial and investment products including investment agreements, derivative products (interest rate, currency and total return swaps) and funding conduits principally to clients of the financial guarantee business. As described above in part I, Item 1, “Introduction”, in 2008 Ambac discontinued writing new investment agreements and derivative products. Its existing investment agreement and derivative product portfolios are in active runoff, which may include transaction terminations, settlements, restructuring, transfers and natural attrition as contracts mature. In the course of managing the inherent risks of these portfolios during runoff, the Financial Services segment may enter into new financial instrument transactions for hedging purposes. As described further below, the Financial Services portfolios obtained funding support from both Ambac Assurance and Ambac Financial Group during 2008 in the form of loans and purchases of invested assets. The principal factors that may affect results as the Financial Services portfolios runoff include: (1) availability of counterparties and pricing for hedging transactions or temporary funding needs; (2) investment returns; (3) future recoveries of temporary investment portfolio impairments as of December 31, 2008; (4) the transaction value of future contract terminations, settlements or transfers which may differ from carrying value of the those assets; (5) future credit rating actions on Ambac Assurance which are linked to most Financial Service contracts; (6) changes in the value of securities posted as collateral; (7) the ability to obtain additional liquidity support from the Financial Guarantee segment or Corporate if needed; and (8) the settlement value of future investment security sales.

Investment Agreements

Ambac provided investment agreements, including repurchase agreements, primarily to issuers of asset-backed and structured finance debt and, to a lesser extent, to municipal issuers through its wholly- owned subsidiary, Ambac Capital Funding. Investment agreements used in structured financings provide a guaranteed investment return customized to meet expected and potential cash flow requirements. Investment agreements are used by municipal bond issuers to invest bond proceeds until such proceeds can be used for their intended purpose, such as financing construction. The investment agreement provides for the guaranteed return of principal invested, as well as the payment of interest thereon at a guaranteed rate and carries the same ratings as Ambac Assurance.

Ambac Capital Funding manages its balance sheet to protect against a number of risks inherent in its business including liquidity, market (principally interest rate), credit, operational and legal risk. See

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“Quantitative and Qualitative Disclosures About Market Risk” located in Part II, Item 7A for further information. Ambac Capital Funding is managed with the goal of closely matching the cash flows of the investment agreement liabilities with the cash flows of the related investment portfolio. To achieve this goal, derivative contracts are used.

A source of liquidity risk is the ability of some counterparties to withdraw monies on dates other than those specified in the draw down schedule. This source of liquidity risk is mitigated by provisions in certain of the investment agreements that limit a counterparty’s ability to draw on the funds and provide notice periods prior to the draw of funds. Despite these measures, 2008 proved to be a challenging year as a result of the global liquidity crisis and distress in the residential mortgage market. Poor credit performance in the structured finance (including mortgage) market, as well as the bankruptcy of Lehman Brothers, resulted in earlier than anticipated investment agreement withdrawals. As stress in the financial markets drove investors to the safety of US government obligations, highly rated structured finance investment securities deemed very liquid under normal market conditions became difficult to sell without realizing a significant discount to book value. Liquidity risk also exists in the portfolio due to contract provisions which require collateral posting or early termination of contracts due to downgrades of Ambac Assurance’s credit ratings. See “Liquidity and Capital Resources” section located in Part II, Item 7 for a discussion on the impact of a ratings downgrade on Ambac Assurance. During 2008, reductions to the balance of outstanding investment agreements resulting from required or negotiated early terminations totaled $3.6 billion, and 84% of investment agreement principal outstanding as of December 31, 2008 was collateralized. Funding for the early terminations was supported in part through various liquidity activities between this entity and Ambac Assurance. See “Introduction” for further discussion of the transactions between Ambac Assurance and the Financial Services segment.

Ambac Capital Funding may use interest rate and currency swap contracts as part of its overall cash flow risk management. Interest rate swap contracts are agreements where Ambac Capital Funding agrees with other parties to exchange, at specified intervals, the difference between fixed-rate and floating-rate interest amounts or the difference between different interest rate indices calculated by reference to an agreed upon notional amount. Currency swap contracts are agreements where Ambac Capital Funding agrees with other parties to exchange foreign currency denominated cash flows for USD denominated cash flows calculated by reference to an agreed upon notional amount.

See Note 8 of Notes to Consolidated Financial Statements located in Part II, Item 8 for further information on investment agreements.

Ambac Securities Inc.’s principal business is to serve as the placement agent and dealer for securities issued by Ambac Capital Funding in private placement transactions. Ambac Securities is registered as a broker-dealer with the SEC and in 42 states and the District of Columbia. Self regulatory organizations such as the Financial Industry Regulatory Authority regulate broker-dealers such as Ambac Securities. In addition, state securities and other regulators also have oversight authority over Ambac Securities. As a registered broker-dealer, Ambac Securities is subject to the net capital requirements of Rule 15c3-1 of the Securities Exchange Act of 1934, as amended, which is designed to measure the general financial condition and liquidity of a broker-dealer. In accordance with this rule, the ratio of aggregate indebtedness to net capital (“net capital ratio”) shall not exceed 15 to 1. At December 31, 2008, Ambac Securities had net capital, as adjusted, of approximately $0.7 million, which was $0.6 million in excess of its required net capital of $100 thousand. The net capital ratio was 0.02 to 1.

Derivative Products

The primary activities in the derivative products business are intermediation of interest rate and currency swap transactions (through Ambac Financial Services) and taking total return swap positions (through Ambac Capital Services) on certain fixed income obligations. All derivatives provided by Ambac Financial Services and Ambac Capital Services are guaranteed by Ambac Assurance through policies that guarantee their obligations to the derivative counterparties.

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Most of Ambac Financial Services’ swap intermediation is hedged on an individual or portfolio basis. A portion of the swap intermediation consists of municipal interest rate swaps which require Ambac to receive a fixed rate and pay either a tax-exempt index rate or an issue-specific bond rate on a variable rate municipal bond. These municipal interest rate swaps are hedged against general interest rate fluctuations but are not hedged between taxable index rates (such as LIBOR) and issue-specific or tax-exempt index rates, which may result in mark-to-market gains or losses. The variable-rate municipal bonds related to our municipal swap transactions typically reset weekly and contain a liquidity facility provided by third party banks. In the event that there is a failed remarketing of the bonds, the liquidity facility provider will purchase the bonds. The underlying variable-rate bonds are typically wrapped by Ambac Assurance. The current dislocation in the credit markets and the recent rating agency actions on Ambac began affecting the marketability of such variable rate bonds in early 2008. This has led to increases in interest rates for those bonds and accordingly increases in Ambac’s payment obligation under the interest rate swaps where we pay an issue-specific rate, resulting in losses on those swaps. These municipal interest rate swaps contain provisions that are designed to protect against certain forms of basis risk or tax reform. These provisions include the ability of Ambac Financial Services to convert its rate from the underlying issue-specific bond rate to an alternative floating rate that is a tax-exempt index rate or a fixed percentage of taxable index rate, in the event that the interest rate on the bond is adversely affected due to a credit downgrade or other events. In certain transactions one or more of these events have occurred and Ambac has exercised its option to convert to the alternative floating rate or has negotiated terminations or restructuring of the swaps.

Interest rate and currency swaps used for hedging purposes are generally subject to master agreements that require increasing collateral levels on mark-to-market liabilities as the counterparties’ credit ratings decline. Some contracts also contain additional termination provisions linked to downgrades of Ambac Assurance, as guarantor of the swaps. As a result of ratings downgrades to Ambac Assurance during 2008, Ambac Financial Services has been subject to lower collateral posting thresholds and in certain transactions additional termination events have occurred. Such termination events have resulted in losses to Ambac Financial Services due to the higher cost of replacing hedge positions in the current credit environment, and may result in additional losses in future periods. During 2008, Ambac Financial Services borrowed from Ambac Financial Group, Inc. and Ambac Assurance, to help support the incremental collateral posting requirements and termination payments resulting from the Ambac Assurance downgrades. At December 31, 200 8, $122 million and $761 million was due from Ambac Financial Services to Ambac Financial Group, Inc. and Ambac Assurance, respectively. See “Introduction” for further discussion of the intercompany lending transactions with the Financial Services segment.

Total return swaps, which were entered into by Ambac Capital Services, were only used for fixed income obligations that meet Ambac Assurance’s credit underwriting criteria. These fixed income obligations are typically guaranteed by Ambac Assurance or another financial guarantor. These contracts include collateral posting requirements associated with the credit rating of Ambac Assurance. As a result of Ambac Assurance’s downgrade, Ambac Capital Services posted collateral of $46 million and terminated total return swaps of $298 million in 2008. Additional collateral may be required on the remaining total return swap contracts. See “Credit Ratings and Collateral” in the Liquidity and Capital Resources section for additional description of total return swap settlements and collateral posting.

Ambac Financial Services and Ambac Capital Services manage a variety of risks inherent in their businesses, including credit, market, liquidity, operational and legal. These risks are identified, measured, and monitored through a variety of control mechanisms, which are in place at different levels throughout the organization. See “Quantitative and Qualitative Disclosures About Market Risk” located in Part II, Item 7A for further information.

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Funding Conduits

Ambac has transferred financial assets to two special purpose entities. The business purpose of these entities is to provide certain financial guarantee clients with funding for their debt obligations. The activities of the special purpose entities are contractually limited to purchasing assets from a subsidiary of Ambac, issuing medium-term notes (“MTNs”) to fund such purchases, executing derivative hedges and related administrative services. Ambac Assurance may issue a financial guarantee insurance policy on the assets sold, the MTNs issued or both. As of December 31, 2008, Ambac Assurance had financial guarantee insurance policies issued for all assets and MTNs owned and outstanding by the special purpose entities. Ambac does not consolidate these special purpose entities under SFAS 140 “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities”. See Notes 2 and 10 of Notes to Consolidated Financial Statements located in Part II, Item 8 for further information.

INVESTMENTS AND INVESTMENT POLICY

As of December 31, 2008, the consolidated investments of Ambac had an aggregate fair value of approximately $10.3 billion and an aggregate amortized cost of approximately $12.8 billion. These investments are managed internally by officers of Ambac, who are experienced investment managers. All investments are effected in accordance with the general objectives and guidelines for investments established by Ambac’s Board of Directors. These guidelines encompass credit quality, risk concentration and duration, and are periodically reviewed and revised as appropriate.

As of December 31, 2008, the Financial Guarantee investment portfolio had an aggregate fair value of approximately $7.7 billion and an aggregate amortized cost of approximately $9.4 billion. Ambac Assurance’s investment policy is designed to achieve diversification of its portfolio and only permits investment in fixed income securities, consistent with its goal to achieve the highest after-tax, long-term return while preserving capital. Ambac Assurance is subject to limits on types and quality of investments imposed by the insurance laws and regulations of the States of Wisconsin and New York. In compliance with these laws, Ambac Assurance’s Board of Directors approves any changes or exceptions to the Investment Policy.

The significant rating downgrades of Ambac Assurance by Moody’s and S&P in November of 2008 resulted in the sale of a significant amount of taxable securities (including RMBS) from the Financial Services portfolio to Ambac Assurance as well as the extension of loans from Ambac Assurance to the investment agreement business. These transactions had several impacts on Ambac Assurance’s investment portfolio including a decrease in tax-exempt positions, an increase in taxable investments, and an increase in mortgage backed and asset backed securities.

As of December 31, 2008, the Financial Services investment portfolio had an aggregate fair value of approximately $2.5 billion and an aggregate amortized cost of approximately $3.3 billion. Ambac Capital Funding’s investment policy is designed to achieve the highest after-tax return, and to maintain cash flow that closely matches invested assets to funded liabilities to minimize interest rate and liquidity risk. For further discussion, see “Investment Agreements,” section above.

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The following tables provide certain information concerning the investments of Ambac:

Summary of Investments as of December 31,

Investments by Security Type as of December 31,

Ambac has RMBS exposure in the Ambac Assurance and Financial Services investment portfolios. Please refer to the tables in the Liquidity and Capital Resources—Balance Sheet section below which set forth: (i) the fair value of mortgage and asset-backed securities by classification, (ii) the fair value of residential mortgage- backed securities by vintage and type, and (iii) the ratings distribution of the fixed income investment portfolio by segment.

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EMPLOYEES

As of December 31, 2008, Ambac and its subsidiaries had 328 employees. None of the employees are covered by collective bargaining agreements. Ambac considers its employee relations to be satisfactory.

CORPORATE GOVERNANCE

The Sarbanes-Oxley Act of 2002 requires Chief Executive Officers and Chief Financial Officers to make certain certifications with respect to this report and to Ambac’s disclosure control and procedures and internal control over financial reporting.

Ambac’s Disclosure Committee has the responsibility for ensuring that there is an adequate and effective process for establishing, maintaining and evaluating disclosure controls and procedures for Ambac in connection with its external disclosures. Ambac has a Code of Business Conduct which promotes management’s control philosophy and expresses the values which govern employee behavior and help maintain Ambac’s commitment to the highest standards of conduct. This code can be found on Ambac’s website at www.ambac.com on the “Investor Relations” page followed by “Corporate Governance”. Ambac will disclose on its website any amendment to, or waiver from, a provision of its Code of Business Conduct that applies to its CEO, CFO or Controller. Ambac’s corporate governance guidelines and the charters for the audit and risk assessment committee, governance committee and compensation committee are also available on our website under the “Corporate Governance” page.

References in the risk factors to “Ambac” are to Ambac Financial Group, Inc. References to “we,” “our” and “us” are to Ambac, Ambac Assurance Corporation and Everspan Financial Guarantee Corp., as the context requires.

Difficult economic and other conditions may adversely affect our business results and prospects and we do not expect these conditions to improve in the near future.

Our results of operations are materially affected by conditions in the global capital markets and the economy generally, both in the U.S. and elsewhere around the world. Since mid-2007, the financial services industry and the securities markets generally were materially and adversely affected by significant declines in the values of nearly all asset classes and by a serious lack of liquidity. This was initially triggered by declines in the values of subprime mortgages, but spread to all mortgage and real estate asset classes, to leveraged bank loans and to nearly all asset classes, including equities. The global markets have been characterized by substantially increased volatility and short-selling and an overall loss of investor confidence, initially in financial institutions, but more recently in companies in a number of other industries and in the broader markets. The decline in asset values has caused increases in margin calls for investors, requirements that derivatives counterparties post additional collateral and redemptions by mutual and hedge fund investors, all of which have increased the downward pressure on asset values and outflows of client funds across the financial services industry. In addition, the increased redemptions and unavailability of credit have required hedge funds and others to rapidly reduce leverage, which has increased volatility and further contributed to the decline in asset values.

Market conditions have also led to the failure or merger of a number of prominent financial institutions. Financial institution failures or near-failures have resulted in further losses as a consequence of defaults on securities issued by them and defaults under bilateral derivatives and other contracts entered into with such entities as counterparties. Furthermore, declining asset values, defaults on mortgages and consumer loans, and the lack of market and investor confidence, as well as other factors, have all combined to increase credit default swap spreads, to cause rating agencies to lower credit ratings, and to otherwise increase the cost and decrease the availability of liquidity, despite very significant declines in central bank borrowing rates and other government

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actions. Banks and other lenders have suffered significant losses and have become reluctant to lend, even on a secured basis, due to the increased risk of default and the impact of declining asset values on the value of collateral.

Beginning in 2008, governments, regulators and central banks in the United States and worldwide have taken numerous steps to increase liquidity and to restore investor confidence, but asset values have continued to decline and access to liquidity continues to be very limited.

Such changes in general economic and other conditions have impacted, and may continue to impact, our business, as well as increases in corporate, municipal and/or consumer bankruptcies; increases in defaults and delinquencies on consumer debt (e.g., debt related to credit cards, student loans, auto loans and mortgage and home equity loans) and resulting stress on asset-backed securities and mortgage-backed securities; changes in interest rate levels; continued dislocation and lack of liquidity in the credit and financial markets; changes in domestic and international laws, including tax laws and bankruptcy laws; intervention by governments or courts in financial markets, including the imposition of limits on the ability of mortgagees to foreclose on defaulted mortgage loans and/or to increase interest rates on mortgage loans in accordance with original contract terms; wars and terrorist acts; natural disasters, including earthquakes, floods, windstorms and wildfires; and rising energy, fuel and utility costs could adversely affect the performance of our insured portfolio and our investment portfolio, e.g., leading to increases in losses and loss reserves in our insured portfolio and decreases in the value of our investment portfolio and, therefore, our financial strength. Furthermore, reduction in the volume of capital markets transactions; levels of competition; and changes in investor perception of credit risk could adversely impact the volume and pricing of financial guarantee insurance transactions and therefore adversely impact our business prospects.

There can be no assurance that actions of the U.S. Government, Federal Reserve and other government and regulatory bodies for the purpose of stabilizing the financial markets will achieve the intended effect.

In response to the financial crises affecting the banking system and financial markets and going concern threats to investment banks and other financial institutions, on October 3, 2008, former President Bush signed the Emergency Economic Stabilization Act of 2008 (“EESA”) into law. Pursuant to the EESA, the U.S. Treasury has the authority to, among other things, purchase up to $700 billion of mortgage-backed and other securities from financial institutions for the purpose of stabilizing the financial markets. So far, this authority has been used primarily to make capital available to banks and bank holding companies and to provide other kinds of assistance to a limited number of financial institutions. The Federal Government, Federal Reserve, the Federal Deposit Insurance Corporation and other governmental and regulatory bodies have taken or are considering taking other actions to address the financial crisis, although generally speaking these actions have so far had little to do with existing securities on the balance sheets of financial institutions. There can be no assurance that any extensive action will be taken with respect to any existing assets or as to what impact such action or any of the other actions that have already been taken will have on the financial markets, whether with respect to market volatility, market valuations, the availability of credit or otherwise. Such volatility, low market valuations and relative unavailability of credit could materially and adversely affect our business, financial condition and results of operations, or the trading price of our common stock.

Market risks could adversely impact our assets posted as collateral in respect of investment agreements and interest rate swap and currency swap transactions.

As a result of the downgrade of Ambac Assurance’s financial strength rating, we are required to post collateral with respect to certain investment agreement, total return swap and interest rate swap and currency swap transactions. See Part II, Item 7, “Management’s Discussion and Analysis—Liquidity and Capital Resources—Credit Ratings and Collateral” of this Annual Report on Form 10-K. We will be required to post additional collateral if the market value of the assets used to collateralize our obligations under such agreements and transactions declines or, in certain cases, if there are changes in the collateral posting obligations under the interest rate swap and currency swap transactions.

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These collateral-posting obligations could have a material adverse effect on our liquidity. At present, these collateral-posting requirements are being satisfied by means of the purchase of assets from the Financial Services businesses by Ambac Assurance and by loans from AFGI and Ambac Assurance to the Financial Services businesses. As required by Wisconsin law, these transactions were approved by the Office of the Commissioner of Insurance for the State of Wisconsin (“OCI”). To the extent that collateral-posting requirements increase as a result of adverse changes in market conditions, as described above, it is likely that Ambac Assurance would need to provide increased lending capacity to the Financial Services businesses in order to satisfy these collateral-posting obligations. Any such increases to lending capacity would be subject to the prior consent of the OCI; there can be no assurance that we would obtain such consent. We believe that the OCI would consider several factors in determining whether to grant such consent, including its view of Ambac Assurance’s financial condition at the time of such loan or contribution.

If the Financial Services businesses fail to post collateral as required, counterparties may be entitled to terminate the transactions. Upon such terminations, we could liquidate securities with unrealized mark-to-market losses which could have a material adverse effect on our liquidity and may lead to further downgrades. See Part II, Item 7, “Management’s Discussion and Analysis—Liquidity and Capital Resources—Credit Ratings and Collateral” of this Annual Report on Form 10-K. The termination of such transactions would trigger Ambac Assurance’s obligations to make payments under the financial guarantee insurance policies it previously issued. To the extent that the OCI determines that the payment by Ambac Assurance under such policies could place Ambac Assurance in a hazardous condition, the OCI could seize Ambac Assurance and place it into rehabilitation.

Risks which impact assets in our investment portfolio could adversely affect our business.

Our investment portfolio has been adversely affected by events and developments in the capital markets, including decreased market liquidity for investment assets; market perception of increased credit risk with respect to the types of securities held in our investment portfolio and corresponding credit spread-widening with respect to our investment assets; and extension of the duration of investment assets. Our investment portfolio may be further adversely affected by these and other events and developments in capital markets, including interest rate movements; downgrades of credit ratings of investment securities and/or financial guarantee insurers which insure investment securities; and foreign exchange movements which impact investment assets. At December 31, 2008, approximately 36% of our investment portfolio is insured by financial guarantors, including Ambac. At December 31, 2008, approximately 8% of our investment portfolio comprises “Alt-A” mortgage-backed securities; Moody’s and S&P have recently undertaken a review of Alt-A mortgage-backed securities and have downgraded a large number of such securities. Please refer to the table in “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Balance Sheet” of this Annual Report on Form 10-K, representing the fair value and weighted-average underlying rating, excluding the financial guarantee, of the insured securities at December 31, 2008.

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During the course of 2008, management identified and periodically revised certain investment securities in the Financial Services investment portfolio to potentially sell in order to satisfy additional collateral posting requirements upon a further ratings downgrade and/or to meet potential liquidity needs. We recorded an impairment charge through income on the portion of those securities which were in an unrealized loss position. Additionally, certain mortgage-backed securities held in our investment portfolio have had significant declines in value. Our analysis of the underlying mortgage loans indicates probable losses for a few of these investments. Accordingly, we have recorded an impairment charge through income for these investments. Please refer to Part II, Item 7—Results of Operations—Financial Services, of this Annual Report on Form 10-K, for further information. The impairments in value in the remaining investment portfolio are not deemed other-than- temporary, as such the remaining unrealized losses have been recognized in other comprehensive income. The following table summarizes amortized cost and estimated fair value of investments at December 31, 2008: