10-K

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

(Mark One)

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

For the fiscal year ended December 31, 2004

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

For the transition period from                      to                     

Commission file number 1-10777

Ambac Financial Group, Inc.

(Exact name of Registrant as specified in its charter)

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

(212) 668-0340

(Registrant’s telephone number, including area code)

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

Title of each class	Name of each exchange on which registered
Common Stock, $0.01 per share and Preferred Stock Purchase Rights	New York Stock Exchange, Inc.

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

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. x

Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2) Yes x No ¨

The aggregate market value of voting stock held by non-affiliates of the Registrant as of the close of business on June 30, 2004 was $7,963,272,372 (based upon the closing price of the Registrant’s shares of the New York Stock Exchange on that date, which was $73.44). 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 7, 2005, 108,942,699 shares of Common Stock, par value $0.01 per share, (net of 2,256 treasury shares) were outstanding.

Documents Incorporated By Reference

Portions of the Registrant’s Annual Report to Stockholders for the year ended December 31, 2004 are incorporated by reference into Parts II and IV hereof. Portions of the Registrant’s Proxy Statement dated March 24, 2005 in connection with the Annual Meeting of Stockholders scheduled to be held on May 3, 2005 are incorporated by reference into Part III hereof.

TABLE OF CONTENTS

		Page
PART I
Item 1.	Business	1
Item 2.	Properties	25
Item 3.	Legal Proceedings	25
Item 4.	Submission of Matters to a Vote of Security Holders	26
PART II
Item 5.	Market for Registrant’s Common Equity and Related Stockholder Matters	26
Item 6.	Selected Financial Data	26
Item 7.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	26
Item 7A.	Quantitative and Qualitative Disclosures About Market Risk	26
Item 8.	Financial Statements and Supplementary Data	26
Item 9.	Changes in and Disagreements With Accountants on Accounting and Financial Disclosure	27
Item 9A.	Controls and Procedures	27
Item 9B.	Other Information	27
PART III
Item 10.	Directors and Executive Officers of the Registrant	27
Item 11.	Executive Compensation	27
Item 12.	Security Ownership of Certain Beneficial Owners and Management	28
Item 13.	Certain Relationships and Related Transactions	28
Item 14.	Principal Accountant Fees and Services	28
PART IV
Item 15.	Exhibits, Financial Statement Schedules, and Reports on Form 8-K	28
SIGNATURES		37
FINANCIAL STATEMENT SCHEDULES		S-1

Part I

Item 1. Business.

GENERAL

Ambac Financial Group, Inc., headquartered in New York City, is a holding company whose subsidiaries provide financial guarantee products and other financial services to clients in both the public and private sectors around the world. Ambac Financial Group was incorporated on April 29, 1991. Ambac Financial Group provides financial guarantees for public finance and structured finance obligations through its principal operating subsidiary, Ambac Assurance Corporation. Through its financial services subsidiaries, Ambac Financial Group provides financial and investment products including investment agreements, interest rate and total return swaps and funding conduits, principally to its clients of the financial guarantee business, which include municipalities and other public entities, health care organizations and asset-backed and structured finance issuers. Information about Ambac Financial Group is available through our website at http://www.ambac.com. In addition, our press releases and filings with the Securities and Exchange Commission (“SEC”) are available free of charge on the investor relations portion of our website.

Ambac Assurance and its subsidiary Ambac Assurance UK Limited, which serve the global capital markets, are primarily engaged in guaranteeing public finance and structured finance obligations. Ambac Assurance is the successor to the founding financial guarantee insurance company, which wrote the first bond insurance policy in 1971. Financial guarantee insurance policies written by Ambac Assurance generally guarantee payment when due of the principal of and interest on the guaranteed obligation. 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 has earned triple-A ratings, the highest ratings available from Moody’s Investors Service, Inc. (“Moody’s”), Standard & Poor’s Ratings Services (“S&P”), Fitch, Inc. (“Fitch”) and Rating and Investment Information, Inc. (“R&I”). These ratings are an essential part of Ambac Assurance’s ability to provide credit enhancement. See “Rating Agencies” section.

Ambac Credit Products LLC, a wholly owned subsidiary of Ambac Assurance, primarily provides credit protection in the global markets in the form of structured credit derivatives. These structured 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 required to either (i) purchase the underlying obligation at its par value and a loss is realized for the difference between the par and market value of the underlying obligation or (ii), make a payment equivalent to the difference between the par value and market value of the underlying obligation. Substantially all of Ambac’s structured credit derivative contracts relate to senior tranches of structured finance transactions are partially hedged with various financial institutions or structured with first loss protection. Structured credit derivatives issued by Ambac Credit Products are insured by Ambac Assurance. See “Management’s Discussion and Analysis — Risk Management” in Ambac Financial Group’s 2004 Annual Report to Stockholders for more detail about structured credit derivatives.

In addition to the guarantees on fixed income obligations described above, Ambac, from time to time, enters into transactions that expose the company to risks which may not be

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correlated to credit risk, for example weather-related or other disasters, mortality or other property and casualty type risk characteristics. Ambac underwrites such risks so that first loss must occur before Ambac would become liable in respect of such risks. Additionally, Ambac underwrites such business primarily in relation to broad indices and reference pools which embody diverse risk characteristics.

Ambac Financial Group’s investment agreement business, conducted through its subsidiary, Ambac Capital Funding, Inc., provides investment agreements primarily to municipalities and other public entities, issuers of structured finance obligations and international issuers. Investment agreements issued by Ambac Capital Funding are insured by Ambac Assurance. Investment agreements are primarily used by issuers to invest bond proceeds until the proceeds can be used for their intended purpose. The investment agreement provides for the guaranteed return of principal invested, and for the payment of interest thereon at a guaranteed rate. See “Investment Agreements” section.

Ambac Financial Group provides interest rate and currency swaps through its subsidiary Ambac Financial Services, LLC, primarily to states, municipalities and their authorities, issuers of asset-backed securities and other entities in connection with their financings. Ambac Financial Group also enters into total return swaps with professional counterparties through its subsidiary Ambac Capital Services LLC. Total return swaps are generally used for fixed income obligations, which meet Ambac Assurance’s credit underwriting criteria. See “Derivative Products” section.

As a holding company, Ambac Financial Group, Inc. is largely dependent on dividends from Ambac Assurance to pay dividends on its capital stock, to pay principal and interest on its indebtedness, to pay its operating expenses, to purchase its common stock in the open market and to make capital investments in its subsidiaries. Dividends from Ambac Assurance are subject to certain insurance regulatory restrictions. See “Insurance Regulatory Matters — Wisconsin Dividend Restrictions” section and “Management’s Discussion and Analysis — Liquidity and Capital Resources” in Ambac Financial Group’s 2004 Annual Report to Stockholders.

FORWARD-LOOKING STATEMENTS

Materials in this annual report may contain information that includes or is based upon forward-looking statements within the meaning of the Securities Litigation Reform Act of 1995. Forward-looking statements are not historical facts but instead represent Ambac’s belief regarding future events, many of which, by their nature, are inherently uncertain and outside our control. You can identify these statements by the fact that they do not relate strictly to historical or current facts and relate to future plan or objectives and results.

Any or all of Ambac’s forward-looking statements here or in other publications may turn out to be wrong and are based on current expectations and the current economic environment. Ambac’s actual results may vary materially, and there are no guarantees about the performance of Ambac’s securities. Among factors that could cause actual results to differ materially are: (1) changes in the economic, credit or interest rate environment in the United States and abroad; (2) the level of activity within the national and worldwide debt markets; (3) competitive conditions and pricing levels; (4) legislative and regulatory developments; (5) changes in tax laws; (6) the policies and actions of the United States and other governments and (7) other risks and uncertainties that have not been identified at this time. Ambac is not obligated to publicly correct or update any forward-looking statement if we later become aware that it is not likely to be achieved, except as required by law. You are advised, however, to

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consult any further disclosures we make on related subjects in Ambac’s reports to the Securities and Exchange Commission.

BUSINESS SEGMENTS

The following paragraphs describe the business operations of Ambac Financial Group, Inc. and its subsidiaries for its two reportable segments: Financial Guarantee and Financial Services.

Financial Guarantee

Generally, financial guarantee insurance written by Ambac Assurance guarantees to the holder of the underlying obligation timely payment of principal and interest on such obligation in accordance with its original payment schedule.

Financial guarantee insurance is a form of credit enhancement that benefits both the issuer and the investor. Issuers benefit because their insured securities are sold with the highest available credit rating, resulting in interest cost savings and greater marketability. In addition, for complex financings and obligations of issuers that are not well known by investors, credit enhanced obligations receive greater market acceptance than obligations without credit enhancement. Investors benefit from greater marketability, secondary market price stability, active credit surveillance and protection from loss associated with issuer default.

Ambac Financial Group 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. Financial guarantee revenues were $1,168.7 million, $1,033.6 million, and $816.2 million in 2004, 2003, and 2002, respectively. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Note 18 of Notes to Consolidated Financial Statements in Ambac Financial Group’s 2004 Annual Report to Stockholders.

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. Total gross par guaranteed for the years ended December 31, 2004, 2003 and 2002 were $118.1 billion, $115.3 billion, and $116.4 billion, respectively.

U. S. Public Finance Market

The U.S. public finance market includes taxable and tax-exempt bonds, notes and other evidences of indebtedness issued primarily by states, political subdivisions (e.g., cities, counties and towns), water, sewer, electric and other utility districts, airports, higher educational institutions, hospitals, transportation and housing authorities. 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. More recently, the public finance market has expanded to include structured, project finance and asset-backed bond issues for infrastructure projects, sports stadiums, and other municipal purposes. This portion of the market is growing and has become a focus for Ambac Assurance in recent years. The following table sets forth the volume of new issues of long-term (longer

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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

($ in Billions)	New Money	Refundings	Total Volume	Refundings as Percentage of Total Volume	Insured Volume	Insured Bonds as Percentage of Total Volume
1995	126.1	33.9	160.0	21.1	68.5	42.8
1996	139.1	45.9	185.0	24.8	85.7	46.3
1997	160.3	60.2	220.5	27.3	107.5	48.8
1998	204.7	82.0	286.7	28.6	145.5	50.7
1999	189.3	38.3	227.6	16.8	105.6	46.4
2000	181.2	19.5	200.7	9.7	79.3	39.5
2001	223.6	64.7	288.3	22.4	134.3	46.6
2002	266.6	92.2	358.8	25.7	178.9	49.9
2003	290.0	94.0	384.0	24.5	190.1	49.5
2004	272.6	87.8	360.4	24.4	194.0	53.8

Source:  Amounts, except for 2004, are estimated data reported by The Bond Buyer’s 2003 Yearbook. The 2004 amounts are Ambac Assurance estimates, compiled from industry sources including Securities Data Company, Inc. and The Bond Buyer. Amounts represent gross par amounts issued or insured, respectively, during such year.

The foregoing table illustrates the changes in the total volume and insured volume of new issues of public finance bonds over the past ten years. Changes in volume of public finance bond issuance during this period are primarily attributable to changes in refunding activity related to the then-current interest rate environment, along with the issuers new money requirements. Total volume in 2002 and 2003 were record issuances as a result of the low interest rate environment and considerable infrastructure finance needs. Total volume in 2004 was down 6% from the record set the previous year. Insured volume, as a percentage of total volume (“insured penetration”), which had grown consistently from 1995 through 1998, declined during 1999 and 2000. The decline during 2000 is generally considered to have resulted from the combination of the relatively high credit quality of issues that came to market during the period and the firmness in premium pricing in the industry. During 2001 through 2004, the insured penetration has increased, largely the result of budget deficits experienced by municipalities and the corresponding flight to quality by investors.

Ambac Assurance guaranteed gross par of $44.6 billion, $43.0 billion and $42.3 billion in 2004, 2003 and 2002, respectively, in the U.S. public finance market.

In the U.S. public finance market, an issuer typically pays an up-front premium to Ambac Assurance at the time the policy is issued. Premiums are usually quoted as a percentage of the total amount of principal and interest that is scheduled to become due during the life of the insured bonds.

Proposed new public finance bond issues are submitted to Ambac Assurance by issuers (or their investment bankers or financial advisors) to determine their suitability for financial insurance. Public finance bond issues are sold on either a competitive or a negotiated basis. With respect to competitive issues, an issuer will publish a notice of sale soliciting bids for the purchase of a proposed issue of bonds. Potential bidders on the bonds then form syndicates. These syndicates then solicit a determination from some or all of the financial guarantors whether an issue is suitable for financial guarantee and at what premium rate and on what terms. The syndicate then determines whether to bid on the issue with a financial guarantee (and if so, with which financial guarantor) or without a financial guarantee. The issuer then generally selects the syndicate with the lowest bid. In a negotiated offering, the issuer has

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already selected an investment bank and that investment bank solicits premium quotes and terms from the financial guarantors.

Ambac Assurance also provides financial guarantees on public finance bonds outstanding in the secondary market that are typically purchased by an institution to facilitate the sale of bonds in its portfolio or inventory. The financial guarantee generally increases the sale price of bonds (typically by an amount greater than the cost of the policy) and affords a wider secondary market and therefore greater marketability to a given issue of previously issued bonds. As is the case with new issues, the premium is generally payable in full at the time of policy issuance. Ambac Assurance employs the same underwriting standards on secondary market issues that it does on new public finance issues.

As of December 31, 2004 and 2003, net outstanding par exposure related to public finance bond transactions was $239.7 billion and $215.3 billion, respectively. See “Financial Guarantees in Force—Types of Bonds” section, for a breakout of net outstanding par exposure by bond type.

U.S. Structured Finance and Asset-backed Market

Financial guarantees of securities in the U.S. structured finance and asset-backed market are typically issued in connection with transactions in which the securities being issued are secured by or payable from a specific pool of financial or tangible assets. This pool of assets has an identifiable cash flow or market value and is generally held by a special purpose entity. Structured finance and asset-backed obligations insured by Ambac Assurance generally have the benefit of over-collateralization and/or other forms of credit enhancement to mitigate credit risks associated with the related assets. These forms of credit enhancement are designed to absorb the expected losses in these transactions.

Structured finance obligations include the securitization of a variety of asset types such as mortgages, home equity loans, auto loans, student loans, credit card debt, leases, commercial asset-backed securities and pooled debt obligations originated in the United States (“Structured Finance”). Currently, the largest component of Ambac’s Structured Finance business relates to the securitization of mortgages and home equity loans. Another target area in Structured Finance is the credit enhancement of pooled debt obligations, including structured credit derivatives. These transactions involve the securitization of a diverse portfolio of corporate bonds and loan obligations and asset-backed securities (the “Securitized Assets”). The transaction structure provides certain financial protection to Ambac. This financial protection can take several forms, however, the most common are over-collateralization, first loss retention and excess spread. In the case of over-collateralization (i.e., the principal amount of the Securitized Assets exceeds the principal amount of the structured finance obligations guaranteed by Ambac Assurance), the structure allows the transaction to experience defaults among the Securitized Assets before a default is experienced on the structured finance obligations that have been guaranteed by Ambac. In the case of first loss retention, the financial guarantee insurance policy only covers a senior layer of losses. A subordinated layer of losses is either retained by the seller or sold off in the form of equity and mezzanine debt to other investors. In the case of excess spread, the financial assets generate cash flow in the form of interest that is in excess of the interest payments on the related debt. All or a portion of this excess spread is applied to redeem structured finance obligations, thus creating over-collateralization.

Structured finance also encompasses credit enhancement for asset-backed commercial paper conduits (“conduits”). Conduits are used by issuers to efficiently fund assets in the

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short-term 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, of which Ambac provides a senior portion.

Unlike the public finance market in which a substantial portion of the deals is bid competitively by the financial guarantors, the structured and asset-backed market is essentially a negotiated one. The financial guarantor will work directly with the investment bank or client to create an acceptable structure once having been awarded the business.

The U.S. structured finance and asset-backed market in which Ambac Assurance provides financial guarantees is broad and varied, comprising public issues and private placements. The increasing array of classes of assets securitized or guaranteed, and the recent rapid changes to the market, makes estimating the size of the markets that we participate in difficult.

Premiums for structured finance and asset-backed policies are typically based on a percentage of principal insured. The timing of the collection of structured finance and asset-backed premiums can be collected in a single payment at policy inception date or collected periodically (e.g., monthly, quarterly or annually) from the cash flow generated by the underlying assets.

As of December 31, 2004 and 2003, net outstanding par exposure related to U.S. structured finance and asset-backed transactions was $132.5 billion and $124.1 billion, respectively. See “Financial Guarantees in Force—Types of Bonds” section, for a breakout of net outstanding par exposure by bond type.

International Finance Market

Outside of the United States, structured and asset-backed issuers, utilities, sovereign and sub-sovereign issuers, and other issuers are increasingly using financial guarantee products, particularly in markets throughout Western Europe. A number of important trends in international finance markets have contributed to this expansion. In the United Kingdom, ongoing privatization efforts have shifted certain risks associated with the development or operation of infrastructure projects from the government to market participants, thus prompting investors in such projects to seek the security of financial guarantee products. These privatization efforts are currently being initiated in other European countries, including Spain, Portugal and Italy. In Western Europe and the emerging markets, there also is growing interest in asset-backed securitization.

While the principles of securitization have been increasingly applied in overseas markets, development in particular countries has varied as a result of the relative sophistication of the local capital markets and the impact of legal and financial regulatory requirements. It is anticipated that securitization will continue to expand internationally, albeit at varying rates in each country. Ambac Assurance, and through its United Kingdom subsidiary Ambac Assurance UK Limited, insures a wide array of obligations in the international finance markets including infrastructure finance, asset-backed and structured finance transactions, utilities, whole company securitizations (i.e. securitizations of substantially all of the operating assets of corporate credits typically engaged in the provision of utility services or infrastructure) and other obligations in selected international finance markets.

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Ambac Assurance’s strategy in the international finance markets is to strengthen its franchise in developed markets by focusing on high quality infrastructure, structured finance, securitization, and utility finance transactions, and in emerging markets by focusing on top tier future flow transactions (structured transactions secured by U.S. Dollar cash flows generated from exports or payment remittances) and pooled debt 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 European Union. In February 2005, Ambac UK has established a branch office in Milan, Italy. Ambac UK has entered into net worth maintenance and reinsurance agreements with Ambac Assurance, which support its triple-A ratings.

Ambac Assurance is party to an alliance in Japan with Sompo Japan Insurance Inc. (“Sompo Japan”). Although the development of the Japanese securitization market has been slow, we believe that this alliance is competitively positioned for future growth.

While there is evidence that the volume of international structured finance transactions has increased significantly in the recent past, unlike the public finance and domestic asset-backed markets, there are few statistics that effectively track volume in the global markets. There are several reasons for this, including the varied nature of the deals coming to market, the early stages of development of certain asset classes and the fact that many international deals are privately placed.

Premiums for international finance policies are based on a percentage of either principal or principal and interest insured. The timing of the collection of international finance premiums varies among individual transactions; some being collected in a single payment at policy inception date, and others being collected periodically (i.e., monthly, quarterly or annually).

As of December 31, 2004 and 2003, net outstanding par exposure related to international finance transactions was $87.3 billion and $86.4 billion, respectively. See “Financial Guarantees in Force - Types of Bonds” section, for a breakout of net outstanding par exposure by bond type.

Risk Management

Ambac Financial Group has a Portfolio Risk Management Committee (“PRMC”) which has established various procedures and controls to monitor and manage credit risk. The PRMC consists of senior risk management professionals and senior management of Ambac Financial Group. 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.

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 from time to time 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. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Note 2 and Note 6 of Notes to

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Consolidated Financial Statements in Ambac Financial Group’s 2004 Annual Report to Stockholders.

The underwriting process involves review of structural, legal, political and credit issues, including compliance with current Ambac Assurance underwriting standards. These standards are reviewed periodically by management. Additionally, the underwriting process often entails on-site due diligence covering the parties to the transaction, such as the issuer, originator, servicer or manager.

The decision to guarantee an issue is based upon such credit factors as the issuer’s ability to repay the bonds, the bond’s security features and the bond’s structure, rather than upon an actuarial prediction of the likelihood that the issuer will default on the underlying debt obligation.

Members of Ambac Assurance’s underwriting staff 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 depends in part on Ambac Assurance’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. Ambac Assurance has three established credit committees comprised of senior credit officers, credit and market risk managers and attorneys. All Structured and International Finance credits and large, complex or new types of Public Finance credits, recommended by the underwriting group, must be formally presented to the credit committee for approval. For certain Public Finance issues, the primary analyst’s recommendation must be approved by a concurring analyst and credit officer and need not be formally presented to the credit committee for approval.

Ambac Assurance assigns internal ratings to individual exposures as part of the underwriting process and at surveillance reviews. These internal ratings, which represent Ambac Assurance’s independent judgments, are based upon underlying credit parameters similar to those used by rating agencies.

Public Finance Underwriting:

In addition to general underwriting standards, each asset class, and bond type within each asset class, has more specific underwriting criteria. For example, the critical risk factors for public finance credits will include the credit quality of the issuer, type of issue, the repayment source, the type of security pledged, the presence of restrictive covenants, and the bond’s maturity. Each bond issue is evaluated in accordance with, and the final premium rate is a function of, the particular factors as they relate to such issue.

Underwriting criteria that are applied for each bond type reflect the differences in, for example, economic and social factors, debt management, project essentiality, financial management, legal and administrative factors, revenue sources and security features.

Structured Finance Underwriting:

Structured finance and asset-backed obligations generally entail three forms of risks: asset risk, which relates to the amount and quality of the underlying assets; structural risk, which relates to the extent to which the transaction’s legal structure provides protection from loss; and execution 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, standards and procedures.

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In general, the amount and quality of asset coverage required is determined by the historical performance of the underlying asset type or the transaction’s specific underlying assets. The future performance or value of the underlying pool of assets will generally determine whether the amount of over-collateralization or other credit enhancement ultimately is sufficient to protect investors, and therefore the guarantor, against adverse asset performance. The ability of the servicer or manager to properly service and/or manage the underlying assets often is a factor in determining future asset performance.

Structured and asset-backed securities are usually designed to 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 the special purpose entity. Other issues include whether the sale of the assets by the originator to the issuer would be respected in the event of the bankruptcy or insolvency of the originator and whether the servicer of the assets may be permitted or required to delay the remittance to investors of any cash collections held by it or received by it after the time it becomes subject to bankruptcy or insolvency proceedings.

Within the mortgage-backed and home equity loan market, Ambac Assurance seeks to work with higher quality, well-capitalized issuers. The issuers typically originate or purchase residential mortgages, home equity loans or home equity lines of credit, which are in turn sold by the issuers in the form of asset-backed securities. In considering whether to guarantee these securities, Ambac Assurance analyzes the quality of the underlying assets, the structure of the securitization, the experience and financial strength of the servicer of the underlying assets and the credit quality of the issuer.

The following table presents the top five servicers by net par outstanding, for the consumer asset-backed exposures, are as follows:

Servicer ($ in Millions)	Net par outstanding
Homecomings Financial Network	$	14,144
Countrywide Home Loans, Inc.		14,043
HomeLoan Management Ltd.		8,412
Chevy Chase Bank, F.S.B.		4,064
Nelnet		3,861

International Finance Underwriting:

In the international markets, Ambac Assurance seeks to guarantee transactions of the same high credit standards it applies in its U.S. business. However, 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 markets receiving Ambac Assurance’s primary international focus have been the United Kingdom, Australia, Italy, Germany and certain parts of Latin America. In addition, Ambac Assurance has guaranteed transactions in which the geographic risk is spread over multiple countries. The types of international obligations guaranteed have primarily been pooled debt obligations, asset-backed securities, special revenue and infrastructure obligations.

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Management believes that risk associated with its international book of business is similar in risk type to its domestic structured finance book of business and, in fact, international transactions may include components of domestic exposure.

Pricing:

Ambac Assurance determines premium rates on the basis of the type of transaction and its assessment of the risk it is assuming. Factors considered in pricing include term to maturity, structure of the issue, and credit and market factors including security features and other credit enhancement features. Additionally, the interest rate spread between insured and uninsured obligations with characteristics similar to those of the proposed bond issue is considered in the pricing process as well as the cost and the projected return to Ambac Assurance. The premium rate for a new issue also takes into account the benefits to be obtained by the issuer.

Overall, the business environment has become more competitive. This increased competition has had a moderately adverse impact on pricing. Credit spreads and pricing continue to provide adequate returns in most markets.

Surveillance and Remediation:

The Surveillance Group is responsible for monitoring outstanding financial guarantee exposures. Active surveillance enables Ambac’s Surveillance Group to track single credit migration or industry credit trends. 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 the risk inherent in the nature of the credits. The focus of the surveillance review is to determine credit trends and recommend appropriate classifications, ratings and review periods. Surveillance analysts and other credit professionals review the financial guarantee portfolio for concentration of risk by (i) specific bond types; (ii) geographic location; and (iii) size of issue. The separate underwriting groups are also responsible for portfolio analysis which entails a broader examination of trends in specific asset classes and bond types.

Surveillance of the credit quality of underlying reference obligations in the structured credit derivatives portfolio is performed on a regular basis. Credit spreads, which act as a measure of the market’s perception of an issuer’s credit quality, are monitored to identify potential problems. In addition, published credit ratings and current news reports are monitored regularly.

Those issues that are either in default or have developed problems that eventually may lead to a claim or loss are tracked closely by the appropriate surveillance team and reporting to management and Ambac’s Board of Directors by preparation of an adversely classified credit listing. Relevant information, along with the schedule of corrective actions, is reviewed in the regular remedial credit meetings. Internal and/or external counsel generally reviews the documents underlying any problem credit and if applicable, an analysis is prepared 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.

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Financial Guarantees in Force

Ambac Assurance underwrites and prices financial guarantees on the assumption that the guarantee will remain in force until maturity of the underlying bonds. Ambac Assurance estimates that the average life of its guarantees on par in force at December 31, 2004 was 11 years. The 11 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 par guaranteed. No assumptions are made for future refundings of guaranteed issues.

Ambac Assurance seeks to maintain a diversified financial guarantee portfolio designed to spread its risk based on a variety of criteria, including issue size, type of bond, geographic area and issuer.

As of December 31, 2004, the total net par amount of guaranteed bonds outstanding was $459.4 billion.

Types of Bonds

The table below shows the distribution by bond type of Ambac Assurance’s guaranteed portfolio as of December 31, 2004.

Guaranteed Portfolio by Bond Type

as of December 31, 2004 ⁽¹⁾

Bond Type	Net Par Amount Outstanding		% of Total Net Par Amount Outstanding
($ In Millions)
U.S. Public Finance:
Lease and tax-backed revenue	$	76,012	16	%
General obligation		49,394	11
Utility revenue		36,321	8
Health care revenue		23,977	5
Transportation revenue		21,188	5
Higher education		18,056	4
Housing revenue		9,163	2
Other		5,588	1
Total U.S. Public Finance		239,699	52
U.S. Structured Finance:
Mortgage-backed and home equity		53,148	12
Asset-backed and conduits		28,858	6
Investor-owned utilities		15,449	3
Student loans		14,646	3
Pooled debt obligations		13,382	3
Other		6,971	2
Total U.S. Structured Finance		132,454	29
Total Domestic		372,153	81
International Finance (2):
Pooled debt obligations		35,911	8
Mortgage-backed and home equity		19,644	4
Asset-backed and conduits		15,692	4
Investor-owned and public utilities		5,965	1
Transportation revenue		4,938	1
Sovereign/sub-sovereign		3,224	1
Other		1,905	0
Total International Finance		87,279	19
Grand Total	$	459,432	100	%

⁽¹⁾ Included in the above exposures is $43,478 of structured credit derivatives at December 31, 2004.

⁽²⁾ International Finance transactions includes components of domestic exposure.

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The table below shows the percentage, by bond type, of new business guaranteed by Ambac Assurance during each of the last three years.

New Business Guaranteed by Bond Type ⁽¹⁾

Bond Type	2004		2003		2002
U.S. Public Finance:
Lease and tax-backed revenue	13	%	12	%	12	%
General obligation	10		8		6
Utility revenue	5		5		6
Health care revenue	3		4		2
Transportation revenue	3		4		4
Higher education	3		3		3
Housing revenue	1		1		2
Other	—		—		1
Total U.S. Public Finance	38		37		36
U.S. Structured Finance:
Mortgage-backed and home equity	23		21		22
Asset-backed and conduits	12		10		10
Student loans	3		3		3
Pooled debt obligations	3		4		3
Investor-owned utilities	1		2		3
Other	3		4		1
Total U.S. Structured Finance	45		44		42
Total Domestic	83		81		78
International Finance:
Mortgage-backed and home equity	5		5		3
Asset-backed and conduits	5		5		4
Pooled debt obligations	3		6		14
Sovereign/sub-sovereign	1		—		—
Transportation revenue	1		2		—
Investor-owned and public utilities	1		1		1
Other	1		—		—
Total International Finance	17		19		22
Grand Total	100	%	100	%	100	%

⁽¹⁾ Stated as a percentage of total gross par amounts guaranteed during such year.

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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 as of December 31, 2004 reflects the historical emphasis on issues guaranteed with an original par amount of less than $25 million. However, U.S. structured finance and international finance transactions have an emphasis on larger deals. The following table sets forth the distribution of Ambac Assurance’s guaranteed portfolio as of December 31, 2004, with respect to the original size of each guaranteed issue:

Par Amount Per Issue

as of December 31, 2004

Original Par Amount	Number of Issues	% of Total Number of Issues		Net Par Amount Outstanding		% of Total Net Par Amount Outstanding
				($ In Millions)
Less than $10 million	8,226	54	%	$	28,525	6	%
$10-25 million	3,104	20			39,344	9
$25-50 million	1,593	10			45,727	10
Greater than $50 million	2,440	16			345,836	75
	15,363	100	%	$	459,432	100	%

Geographic Area

Ambac Assurance is 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, 2004.

Guaranteed Portfolio by Geographic Area as of December 31, 2004

Geographic Area	Net Par Amount Outstanding		% of Total Net Par Amount Outstanding
($ In Millions)
Domestic:
California	$	45,980	10	%
New York		28,814	6
Florida		19,062	4
Texas		15,128	3
Pennsylvania		13,699	3
New Jersey		12,202	3
Illinois		11,952	3
Massachusetts		8,730	2
Ohio		8,295	2
Michigan		7,053	1
Mortgage and asset-backed		82,006	18
Other states		119,232	26
Total Domestic		372,153	81
International:
United Kingdom		26,325	6
Germany		7,842	2
Japan		6,063	1
Australia		4,569	1
Italy		1,641	—
Internationally diversified		32,685	7
Other international		8,154	2
Total International		87,279	19
Grand Total	$	459,432	100	%

Mortgage and asset-backed obligations include guarantees with multiple locations of risk within the United States. Internationally diversified includes pooled debt obligations which includes components of domestic exposure.

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The table below shows the distribution by currency of Ambac Assurance’s guaranteed portfolio as of December 31, 2004:

Currency	Net Par Amount Outstanding in Base Currency	Net Par Amount Outstanding in U.S. Dollars
(Amounts In Millions)
U.S. Dollars	394,789	$	394,789
Euros	25,944		35,173
British Pounds	11,052		21,174
Australian Dollars	5,227		4,092
Japanese Yen	380,233		3,713
Other			491
Total		$	459,432

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 less than 1.0% of aggregate net par amount insured. Ambac Assurance is also subject to certain regulatory limits and rating agency guidelines on exposure to a single credit. See “Insurance Regulatory Matters” and “Rating Agencies,” sections.

Competition

The financial guarantee business is highly competitive. Ambac Assurance’s principal competitors in the market for financial guarantees are three other triple-A rated monoline insurance companies, Financial Guaranty Insurance Company (“FGIC”), Financial Security Assurance Inc. (“FSA Guarantee”) and MBIA Insurance Corporation (“MBIA”). XL Capital Assurance, Inc. (“XL”) is also a triple-A rated insurance company, and while generally not a strong competitor in the broad market, it has been strong in certain sectors of the market. In addition, banks, smaller and lower rated financial guarantee insurance companies, multiline insurers and reinsurers represent additional participants in the market.

The principal competitive factors 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) the financial strength of the guarantor; and (iv) the quality of service provided to issuers, investors and other clients of the issuer. With respect to each of these competitive factors, Ambac Assurance believes it is on at least equal footing with each of its principal competitors. Financial guarantee insurance competes with other forms of credit enhancement, including senior-subordinate structures and letters of credit issued by other financial institutions. Financial guarantee insurance also competes, 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 are not greater than the cost of insurance, 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, under different credit rating scenarios. As credit spreads tighten, the likelihood that issuers will choose to issue bonds without credit enhancement increases.

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The current environment is very competitive. Senior subordinated structures in the mortgage-backed sector reduced the number of transactions eligible for insurance. As a result of the tight credit spreads noted above, the pooled debt obligation market has decreased significantly, adversely impacting Ambac’s growth in the market. Competitive and credit trends such as the ones we are currently experiencing in mortgage-backed securities and international pooled debt obligations are a normal part of Ambac’s business.

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 triple-A 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. Additionally, the market may increasingly accept guarantees by double–A or lower rated insurers, who have less stringent capital requirements. Under the New York law, a monoline financial guaranty 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.

Reinsurance

State insurance laws and regulations (as well as the rating agencies) impose minimum capital requirements and single risk limits on financial guarantee insurance companies, limiting the aggregate amount of insurance which may be written and the maximum size of any single risk exposure which may be underwritten. Ambac uses reinsurance to diversify risk, increase underwriting capacity, manage capital needs, stabilize shareholder returns and strengthen financial ratios. See “Insurance Regulatory Matters,” section.

Ambac Assurance has facultative and treaty reinsurance agreements with reinsurers that 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 current reinsurance program includes a surplus share treaty that allows Ambac Assurance to secure reinsurance on large domestic and international transactions. Additionally, Ambac Assurance utilizes facultative reinsurance when needed. A ceding commission is withheld by Ambac Assurance to defray its underwriting and operating expenses. The largest reinsurer accounts for 2% of gross par outstanding at December 31, 2004. See Note 15 of Notes to Consolidated Financial Statements in Ambac Financial Group’s 2004 Annual Report to Stockholders.

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The following table shows the distribution by bond type of Ambac Assurance’s ceded guaranteed portfolio at December 31, 2004:

Ceded Guaranteed Portfolio by Bond Type

as of December 31, 2004

Bond Type	Ceded Par Amount Outstanding		% of Total Gross Par Amount Outstanding
($ In Millions)
U.S. Public Finance:
Lease and tax-backed	$	5,514	1.1	%
General obligation		1,687	0.3
Utility revenue		3,057	0.6
Health care revenue		5,334	1.1
Transportation revenue		2,864	0.6
Higher education		1,126	0.2
Housing revenue		279	0.1
Other		205	0.0
Total U.S. Public Finance		20,066	4.0
U.S. Structured Finance:
Mortgage-backed and home equity		3,397	0.7
Asset-backed and conduits		3,657	0.7
Investor-owned utilities		2,829	0.6
Student loan		1,005	0.2
Pooled debt obligations		723	0.1
Other		922	0.2
Total U.S. Structured Finance		12,533	2.5
Total Domestic		32,599	6.5
International Finance:
Pooled debt obligations		538	0.1
Mortgage-backed and home equity		632	0.1
Asset-backed and conduits		3,239	0.6
Investor-owned and public utilities		3,152	0.6
Transportation revenue		1,317	0.3
Sovereign/sub-sovereign		1,239	0.2
Other		509	0.1
Total International Finance		10,626	2.1
Grand Total	$	43,225	8.6	%

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) has collateral provisions in certain reinsurance contracts, and (iii) has certain cancellation rights that can be exercised by Ambac Assurance in the event of a rating downgrade of a reinsurer. Ambac Assurance’s current primary reinsurers are Ace Guaranty Corporation, Assured Guarantee Reinsurance International, Ltd., Financial Guarantee Insurance Co., MBIA, Radian Reinsurance Inc., Ram Reinsurance Company, Ltd. and Sompo Japan. See financial strength ratings of reinsurers located under the Ceded Premiums Written section of the Management’s Discussion and Analysis of Financial Condition and Results of Operations in Ambac Financial Group’s 2004 Annual Report to Stockholders.

Rating Agencies

Moody’s, S&P, Fitch and R&I periodically review the business and financial condition of Ambac Assurance and other companies providing financial guarantees. These rating agencies’ reviews focus on the guarantor’s underwriting policies and procedures and the quality of the

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obligations guaranteed. The rating agencies have access to all insured obligations and frequently perform assessments of the credits guaranteed by Ambac Assurance to confirm that Ambac Assurance continues to meet the capital allocation criteria considered necessary by the particular rating agency to maintain Ambac Assurance’s triple-A ratings. Ambac Assurance’s ratings have been periodically affirmed by each of the rating agencies and have never been revised downward or put on review for a possible downgrade. Moody’s, S&P, Fitch and R&I’s ratings were last reaffirmed in 2004. A rating by Moody’s, S&P, Fitch or R&I, however, is not a “market rating” or a recommendation to buy, hold or sell any security. Ambac Assurance’s ability to attract new business or to compete with other triple-A rated financial guarantors, and its results of operations and financial condition, would be adversely affected in a material way by any reduction in its ratings.

Insurance Regulatory Matters

General Law

Ambac Assurance is licensed to transact financial guarantee and surety business as an insurance company in all 50 states, the District of Columbia, the Commonwealth of Puerto Rico, the territory of Guam and the U.S. Virgin Islands. Ambac Assurance is subject to the insurance laws and regulations of the State of Wisconsin (the “Wisconsin Insurance Laws”), its state of incorporation, and the insurance laws and regulations of other states in which it is licensed to transact business. These laws and regulations, as well as the level of supervisory authority that may be exercised by the various state insurance departments, vary by jurisdiction. They generally require financial guarantors to maintain minimum standards of business conduct and solvency, meet certain financial tests, file certain reports with regulatory authorities, including information concerning their capital structure, ownership and financial condition. They generally require prior approval of certain changes in control of domestic financial guarantors and their direct and indirect parents and the payment of certain dividends and distributions. In addition, these laws and regulations require approval of certain inter-corporate transfers of assets and certain transactions between financial guarantors and their direct and indirect parents and affiliates. They generally require that all such transactions have terms no less favorable than terms that would result from transactions between parties negotiating at arm’s length. Ambac Assurance is required to file quarterly and annual statutory financial statements with the National Association of Insurance Commissioners (“NAIC”), and if required, each jurisdiction in which it is licensed. It is subject to single and aggregate risk limits and other statutory restrictions concerning the types and quality of investments and the filing and use of policy forms and premium rates. Additionally, Ambac Assurance’s accounts and operations are subject to periodic examination by the Office of the Commissioner of Insurance of the State of Wisconsin (the “Wisconsin Commissioner”) and other state insurance regulatory authorities. See Note 17 of Notes to Consolidated Financial Statements in Ambac Financial Group’s 2004 Annual Report to Stockholders.

Ambac UK, an Ambac Assurance wholly owned subsidiary, is licensed to transact credit, suretyship and financial guarantee insurance in the United Kingdom and to offer insurance services into thirteen other European Union countries. Ambac Credit Products Limited, also an Ambac Assurance wholly-owned subsidiary, is licensed in the United Kingdom to transact credit default derivatives, as well as act as agent for Ambac Credit Products LLP and Ambac Capital Funding. Ambac Credit Products Limited is currently able to offer services in two other European Union countries.

Ambac UK and Ambac Credit products Limited are each subject to regulation by the Financial Services Authority (“FSA”) of the United Kingdom in the conduct of their business.

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Under FSA regulations, each company is subject to certain requirements and limits, including risk assessments and the maintenance of a minimum margin of solvency. The FSA monitors each regulated company through site visits and required financial filings. The FSA requires approval of related party transactions and requires that all such transactions have terms no less favorable than terms that would result from transactions between parties negotiating at arm’s length.

Ambac Financial Group believes that Ambac Assurance and Ambac UK are in material compliance with all applicable insurance laws and regulations.

Insurance Holding Company Laws

Under the Wisconsin insurance holding company laws, any acquisition of control of Ambac Financial Group and thereby indirect control of Ambac Assurance requires the prior approval of the Wisconsin Commissioner. “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 Wisconsin Commissioner, upon application, determines otherwise. For purposes of this test, Ambac Financial Group 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 Financial Group would be deemed to have control of Ambac Assurance within the meaning of the Wisconsin Insurance Laws.

Pursuant to these laws, FMR Corporation and JP Morgan Chase obtained approval from the Wisconsin Commissioner to acquire greater than 10% of Ambac Financial Group’s common stock. As of December 31, 2004, their percentage of ownership was approximately 10.14% and 10.10%, respectively. In their request for approval from the Wisconsin Commissioner, both FMR Corporation and JP Morgan Chase disclaimed any present intent to exercise control over Ambac Financial Group or Ambac Assurance or to control or attempt to control the management of operations of Ambac Financial Group or Ambac Assurance.

The Wisconsin insurance holding company laws also require prior approval by the Wisconsin Commissioner of certain transactions between Ambac Assurance and companies affiliated with Ambac Assurance.

Wisconsin Dividend Restrictions

Pursuant to the Wisconsin Insurance Laws, Ambac Assurance may declare dividends, subject to any restriction 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 the shareholder (other than stock dividends) must be reported to the Wisconsin Commissioner. Extraordinary dividends must be reported prior to payment and are subject to disapproval by the Wisconsin Commissioner. 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.

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During 2004, 2003 and 2002, Ambac Assurance paid to Ambac Financial Group, Inc. cash dividends on its common stock totaling $103.0 million, $89.6 million and $78.0 million, respectively. See Note 17 of Notes to Consolidated Financial Statements in Ambac Financial Group’s 2004 Annual Report to Stockholders.

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. 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. 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. Under NAIC SAP, 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.

New York Financial Guarantee Insurance Law

New York’s comprehensive financial guarantee insurance law 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 guaranty 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 of December 31, 2004 and 2003, Ambac Assurance and its subsidiaries were in compliance with these regulatory requirements.

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, 2004 and 2003, Ambac Assurance and its subsidiaries were in compliance with these regulatory requirements.

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Financial Guarantee Insurance Regulation in Other States

The Wisconsin insurance laws and regulations governing municipal bond guarantors are similar to those in New York. The Wisconsin regulations also include certain single and aggregate risk limitations. The average annual debt service for any single issue of municipal bonds may not exceed 10% of Ambac Assurance’s policyholders’ surplus. 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, which is defined as the sum of its capital and surplus and contingency reserve. As of December 31, 2004 and 2003, 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

Ambac Financial Group’s Financial Services segment provides financial and investment products including investment agreements, interest rate and total return swaps and funding conduits principally to clients of the financial guarantee business, which includes municipalities and other public entities, health care organizations, asset-backed and structured finance issuers.

Financial services revenues are primarily derived from: (i) gross investment income; (ii) net swap revenues; and (iii) net realized gains and losses on sales of securities. Total revenues were $236.3 million, $231.4 million and $137.4 million in 2004, 2003 and 2002, respectively.

The principal competitive factors among providers of financial service products that Ambac Financial Group offers are: (1) pricing of contracts; (2) investment returns; (3) the financial strength of the financial guarantee provider; (4) the ability to provide services tailored to customers’ needs; and (5) the quality of service provided to customers. With respect to each of these competitive factors, Ambac Financial Group believes that it is on equal footing with its principal competitors.

Investment Agreements

The principal purpose of Ambac Capital Funding is to provide investment agreements, including repurchase agreements, primarily to municipalities and their authorities, states, and asset-backed and structured finance issuers. 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. Investment agreements used in structured financings provide a guaranteed investment return customized to meet expected cash flow requirements.

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The investment agreement provides for the guaranteed return of principal invested, as well as the payment of interest thereon at a guaranteed rate and is rated triple-A by virtue of Ambac Assurance’s financial guarantee policy, which guarantees its payment obligations.

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 “Management’s Discussion and Analysis — Risk Management” in Ambac Financial Group’s 2004 Annual Report to Stockholders. Ambac Capital Funding is managed with the goal of matching the payment schedule of the invested assets, including hedges, to the payment schedule of the investment agreement liabilities in order to minimize market and liquidity risk.

A source of liquidity risk is the ability of some counterparties to withdraw moneys on dates other than those specified in the draw down schedule. Liquidity risk is somewhat mitigated by provisions in certain of the investment agreements that limit a counterparty’s ability to draw on the funds and by risk management procedures that require the regular re-evaluation and re-projection of draw down schedules. Investments are restricted to fixed income securities with a credit quality such that the overall minimum average portfolio credit quality is maintained at Aa/AA. Based upon management’s projections, Ambac Capital Funding maintains funds invested in cash and cash equivalents to meet short-term liquidity needs.

The following table sets forth the net payments due under Ambac Capital Funding’s settled investment agreements in each of the next five years ending December 31 and the period thereafter, based on expected call dates:

Investment Agreements Obligations

($ In Thousands)	Principal Amount (1)
2005	$	1,142,049
2006		507,827
2007		1,006,212
2008		834,184
2009		277,610
All later years		2,290,400
	$	6,058,282

⁽¹⁾ As of December 31, 2004, the interest rates on these agreements ranged from 1.10% to 8.08%.

Ambac Capital Funding may use interest rate swap contracts in the normal course of business for hedging purposes 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.

Ambac Securities 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 with certain states that require such registration, and it is a member of the National Association of Securities Dealers, Inc. 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, 2004, Ambac Securities had net capital, as adjusted, of approximately

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$0.6 million, which was $0.5 million in excess of its required net capital of $100 thousand. The net capital ratio was 0.08 to 1.0.

Derivative Products

Ambac Financial Services provides interest rate swaps and other derivative products primarily to states, municipalities and their authorities, issuers of asset-backed securities and other entities in connection with their financings. Ambac Financial Services generally hedges its transactions to mitigate sensitivity to overall interest rates. On interest rate swaps for municipalities, Ambac Financial Services is subject to the risk of changes in the relationship between tax-exempt and taxable interest rates, referred to as “basis risk.” If actual or projected tax-exempt interest rates change in relation to taxable rates, Ambac Financial Services may experience a mark-to-market gain or loss. A portion of these municipal interest rate swaps transacted by Ambac Financial Services contain provisions that are designed to protect Ambac Financial Group against certain forms of tax reform, thus mitigating its basis risk. The interest rate swaps provided by Ambac Financial Services are guaranteed by Ambac Assurance through policies that guarantee the obligations of Ambac Financial Services and its counterparties. Total return swaps, which are entered into by Ambac Capital Services, are only used for fixed income obligations, which meet Ambac Assurance’s credit underwriting criteria.

Ambac Financial Services and Ambac Capital Services are both wholly-owned subsidiaries of Ambac Assurance.

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 “Management’s Discussion and Analysis - Risk Management” in Ambac Financial Group’s 2004 Annual Report to Stockholders.

Investments and Investment Policy

As of December 31, 2004, the consolidated investments of Ambac Financial Group had an aggregate fair value of approximately $14.8 billion and an aggregate amortized cost of approximately $14.3 billion. These investments are managed internally by officers of Ambac Financial Group, 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 holding period, and are periodically reviewed and revised as appropriate.

Pursuant to Statement of Financial Accounting Standards No. 115, “Accounting for Certain Investments in Debt and Equity Securities,” Ambac Financial Group has designated all investments as “available-for-sale” and reports them at fair value. Unrealized gains and losses considered temporary are excluded from earnings and reported as a component of “Accumulated Other Comprehensive Income”, in stockholders’ equity, net of tax. Unrealized losses that are considered other than temporary are recorded as a write down of the asset and are included in net income.

As of December 31, 2004, the Financial Guarantee investment portfolio had an aggregate fair value of approximately $8.7 billion and an aggregate amortized cost of approximately $8.3 billion. Ambac Assurance’s investment policy is designed to achieve diversification of its portfolio and only permits investment in fixed income securities, consistent

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with its goal to achieve the highest after-tax, long-term return. This policy takes into consideration Ambac Assurance’s desire for both current income and long-term capital growth. 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 each specific investment transaction of Ambac Assurance. See “Insurance Regulatory Matters - General Law,” section.

As of December 31, 2004, the Financial Services investment portfolio had an aggregate fair value of approximately $6.1 billion and an aggregate amortized cost of approximately $5.9 billion. Ambac Capital Funding’s investment policy is designed to achieve the highest after-tax return on equity, subject to minimum average quality ratings. For further discussion, see “Investment Agreements,” section.

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

Investments by Rating as of December 31, 2004 ⁽¹⁾

Rating	% of Investment Portfolio
AAA	84	%
AA	10
A	3
BBB	1
Below investment grade	<1
Not rated	2
	100	%

⁽¹⁾ Ratings represent S&P classifications. If unavailable, Moody’s rating is used.

Summary of Investments

As of December 31,

	2004				2003				2002
Investment Category	Carrying Value		Weighted Average Yield (1)		Carrying Value		Weighted Average Yield (1)		Carrying Value		Weighted Average Yield (1)
($ In Thousands)
Long-term investments:
Taxable bonds	$	8,114,307	3.83	%	$	8,155,342	5.07	%	$	7,424,907	5.33	%
Tax-exempt bonds		6,128,653	4.75			5,555,299	5.00			4,716,288	5.19
Total long-term investments		14,242,960	4.22			13,710,641	5.05			12,141,195	5.28
Short-term investments (2)		521,226	2.16			250,382	1.05			395,761	1.28
Other		4,234	—			4,417	—			2,354	—
Total	$	14,768,420	4.14	%	$	13,965,440	4.97	%	$	12,539,310	5.14	%

⁽¹⁾ Yields are stated on a pre-tax basis, based on average amortized cost.

⁽²⁾ Includes taxable and tax-exempt investments.

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Investments by Security Type

As of December 31,

	2004				2003				2002
Investment Category	Carrying Value		Weighted Average Yield (1)		Carrying Value		Weighted Average Yield (1)		Carrying Value		Weighted Average Yield (1)
($ In Thousands)
Municipal obligations (2)	$	6,352,190	4.81	%	$	5,734,046	5.05	%	$	4,887,902	5.24	%
Corporate securities		673,783	5.55			1,086,231	5.84			1,569,314	5.46
Foreign obligations		237,873	4.71			177,179	5.54			120,600	4.93
U.S. government obligations		125,321	4.18			102,212	4.16			108,193	4.27
U.S. agency obligations		876,242	4.76			647,652	5.06			573,061	5.32
Mortgage and asset-backed securities (3)		5,977,551	3.38			5,963,321	4.89			4,882,125	5.28
Total long-term investments		14,242,960	4.22			13,710,641	5.04			12,141,195	5.28
Short-term investments (2)		521,226	2.16			250,382	1.05			395,761	1.28
Other		4,234	—			4,417	—			2,354	—
Total	$	14,768,420	4.14	%	$	13,965,440	4.97	%	$	12,539,310	5.14	%

⁽¹⁾ Yields are stated on a pre-tax basis, based on average amortized cost.

⁽²⁾ Includes taxable and tax-exempt investments.

⁽³⁾ The actual maturity dates of mortgage- and asset-backed securities are uncertain because the underlying collateral may be paid prior to the stated maturity of such securities. This possibility of prepayment creates the risk that Ambac Financial Group will be unable to replace such investments with securities of comparable yield.

Distribution of Investments by Maturity

as of December 31, 2004

Maturity	Amortized Cost		Estimated Fair Value
($ In Thousands)
Due in one year or less (1)	$	596,739	$	606,506
Due after one year through five years		1,023,984		1,055,447
Due after five years through ten years		1,768,158		1,832,337
Due after ten years		4,956,453		5,296,579
		8,345,334		8,790,869
Mortgage and asset-backed securities (2)		5,950,293		5,977,551
Total	$	14,295,627	$	14,768,420

⁽¹⁾ Includes securities with a fair value of $75.5 million, which are classified as long-term investments in the tables above but which mature within one year.

⁽²⁾ The actual maturity dates of mortgage and asset-backed securities are uncertain because the underlying collateral may be paid prior to the stated maturity of such securities. This possibility of prepayment creates the risk that Ambac Financial Group will be unable to replace such investments with securities of comparable yield.

For further discussion, see Note 2 and 3 of Notes to Consolidated Financial Statements in Ambac Financial Group’s 2004 Annual Report to Stockholders.

Employees

As of December 31, 2004, Ambac Financial Group and its subsidiaries had 360 employees. None of the employees are covered by collective bargaining agreements. Ambac Financial Group considers its employee relations to be satisfactory.

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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 the company’s disclosure control and procedures and internal control over financial reporting.

During the third quarter of 2002, Ambac Financial Group created a Disclosure Committee that has the responsibility for ensuring that there is an adequate and effective process for establishing, maintaining and evaluating disclosure controls and procedures for Ambac Financial Group in connection with its external disclosures. Ambac Financial Group has a Code of Business Conduct that expresses the values that drive employee behavior and maintains Ambac Financial Group’s commitment to the highest standards of conduct. This code can be found on Ambac Financial Group’s website at www.ambac.com by clicking on the “Investor Relations” page followed by “Corporate Governance”. Ambac Financial Group’s corporate governance guideline and the charters for the audit committee, governance committee and compensation committee are also available on our website under the “Corporate Governance” page.

Item 2. Properties.

The principal executive offices of Ambac Financial Group are located at One State Street Plaza, New York, New York 10004. The telephone number is (212) 668-0340.

Ambac Assurance, Ambac Capital Funding, Ambac Financial Services, Ambac Capital Products and Ambac Capital Services maintain their principal executive offices at One State Street Plaza, New York, New York 10004, which consists of approximately 145,000 square feet of office space, under an agreement that expires on September 30, 2019. Ambac Assurance maintains other locations at Otemachi Financial Center 17^th Floor, 5-4, Otemachi 1-chome, Chiyoda-ku, Tokyo 100-0004, Japan and at ABN AMRO Tower, L31, 88 Phillip Street, Sydney 2000 NSW, Australia. Both locations consist of approximately 1,000 square feet of office space.

Ambac UK and Ambac Capital Products Limited maintain its principal offices at Hasilwood House, 60 Bishopsgate, London EC2N4BE, England, which consists of 7,100 square feet of office space, under an agreement that expires in December 2006. Ambac UK has acquired rights to additional space of approximately 12,600 square feet at 6 Broadgate, London EC2 under an agreement that expires in September 2013 and also maintains a representative office at Regus Business Center S.r.l., Via Montedi Pieta N.21, 20121 Milano, Italy.

Ambac Financial Group owns an office building at 905 Marconi Avenue, Ronkonkoma, New York 11779. It currently rents the office space to PFM Asset Management, LLC under an agreement that expires in 2006. The office building consists of approximately 15,000 square feet of office space and storage.

Item 3. Legal Proceedings.

There are no material lawsuits pending, or to the knowledge of Ambac Financial Group threatened, to which Ambac Financial Group or any of its majority-owned subsidiaries is a party.

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Item 4. Submission of Matters to a Vote of Security-Holders.

There were no matters submitted to a vote of security holders during the fourth quarter of 2004.

Part II

Item 5. Market for Registrant’s Common Equity and Related Stockholder Matters.

Information relating to the principal market on which Ambac Financial Group’s Common Stock is tradable, the high and low sales prices per share for each full quarterly period within the two most recent fiscal years, and the frequency and amount of any cash dividends declared for the two most recent fiscal years is set forth on the inside back cover of Ambac Financial Group’s 2004 Annual Report to Stockholders and such information is incorporated herein by reference. Information concerning restrictions on the payment of dividends is set forth in Item 1 above under the caption “Insurance Regulatory Matters - Wisconsin Dividend Restrictions.” As of March 7, 2005, there were 75 stockholders of record of Ambac Financial Group’s Common Stock, which is listed on the New York Stock Exchange.

Item 6. Selected Financial Data.

Selected financial data for Ambac Financial Group and its subsidiaries for each of the last ten fiscal years is set forth under the captions “10-Year Performance” and “Financial Highlights” on page 7 and pages 8 and 9 respectively, of Ambac Financial Group’s 2004 Annual Report to Stockholders. Such information is incorporated herein by reference and should be read in conjunction with the Consolidated Financial Statements and the Notes thereto contained on pages 42 through 69 of such Annual Report.

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

Management’s Discussion and Analysis of Financial Condition and Results of Operations is set forth under the same caption on pages 18 through 38 of Ambac Financial Group’s 2004 Annual Report to Stockholders. Such information is incorporated herein by reference and should be read in conjunction with the Consolidated Financial Statements and the Notes thereto contained on pages 42 through 69 of such Annual Report.

Item 7A. Quantitative and Qualitative Disclosures About Market Risk.

Quantitative and Qualitative Disclosures About Market Risk is set forth under the caption Risk Management on pages 36 to 38 of Ambac Financial Group’s 2004 Annual Report to Stockholders. Such information is incorporated herein by reference and should be read in conjunction with the Consolidated Financial Statements and the Notes thereto contained on pages 42 to 69 of such Annual Report.

Item 8. Financial Statements and Supplementary Data.

The 2004 Consolidated Financial Statements, together with the Notes thereto and the Independent Registered Public Accounting Firm Reports thereon, are set forth on pages 40 through 69 of Ambac Financial Group’s 2004 Annual Report to Stockholders. Such information is incorporated herein by reference.

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Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.

None.

Item 9A. Controls and Procedures

(a) Evaluation of Disclosure Controls and Procedures. Ambac Financial Group’s management, with the participation of Ambac Financial Group’s Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of Ambac Financial Group’s disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)), as of the end of the period covered by this report. Based on this evaluation, Ambac Financial Group’s Chief Executive Officer and Chief Financial Officer have concluded that, as of the end of such period, Ambac Financial Group’s disclosure controls and procedures are effective in recording, processing, summarizing and reporting, on a timely basis, information required to be disclosed by Ambac Financial Group (including its consolidated subsidiaries) in the reports that it files or submits under the Exchange Act.

(b) Changes in Internal Controls Over Financial Reporting. There have not been any changes in Ambac Financial Group’s internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during Ambac Financial Group’s fiscal quarter ended December 31, 2004 that have materially affected, or are reasonably likely to materially affect, Ambac Financial Group’s internal control over financial reporting.

The report called for by Item 308(a) of Regulation S-K is incorporated herein by reference to Management’s Report on Internal Control Over Financial reporting, included in Part II, Item 8 of this report.

The attestation report called for by Item 308 (b) of Regulation S-K is incorporated herein by reference to Report of Independent Registered Public Accounting Firm on Internal Control Over Financial Reporting, included in Part II, Item 8 of this report.

Item 9B. Other Information

None.

Part III

Item 10. Directors and Executive Officers of the Registrant.

This item is omitted because a definitive proxy statement which involves the election of directors will be filed with the Securities and Exchange Commission not later than 120 days after the close of the fiscal year pursuant to Regulation 14A.

Item 11. Executive Compensation.

This item is omitted because a definitive proxy statement which involves the election of directors will be filed with the Securities and Exchange Commission not later than 120 days after the close of the fiscal year pursuant to Regulation 14A.

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Item 12. Security Ownership of Certain Beneficial Owners and Management.

This item is omitted because a definitive proxy statement which involves the election of directors will be filed with the Securities and Exchange Commission not later than 120 days after the close of the fiscal year pursuant to Regulation 14A.

Item 13. Certain Relationships and Related Transactions.

None.

Item 14. Principal Accountant Fees and Services.

This item is omitted because a definitive proxy statement which involves the election of directors will be filed with the Securities and Exchange Commission not later than 120 days after the close of the fiscal year pursuant to Regulation 14A.

Part IV

Item 15. Exhibits, Financial Statement Schedules, and Reports on Form 8-K.

(a) Documents filed as a part of this report:

1. Financial Statements

The following consolidated financial statements included in the 2004 Annual Report to Stockholders are incorporated herein by reference under Part II, Item 8:

	Page Number In Annual Report
Reports of Independent Registered Public Accounting Firm	40-41
Consolidated Balance Sheets as of December 31, 2004 and 2003	42
Consolidated Statements of Operations for each of the years ended December 31, 2004, 2003 and 2002.	43
Consolidated Statements of Stockholders’ Equity for each of the years ended December 31, 2004, 2003 and 2002.	44
Consolidated Statements of Cash Flows for each of the years ended December 31, 2004, 2003 and 2002	45
Notes to Consolidated Financial Statements	46-69

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2. Financial Statement Schedules

The financial statement schedules filed herein, which are the only schedules required to be filed, are as follows:

Report of Independent Registered Public Accounting Firm			(Page S-1)
Schedule I	—	Summary of Investments Other Than Investments in Related Parties	(Page S-2)
Schedule II	—	Condensed Financial Information of Registrant (Parent Company Only)	(Pages S-3 to S-7)
Schedule IV	—	Reinsurance	(Page S-8)

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3. Exhibits

The following items are annexed as exhibits:

Exhibit Number	Description
3.01	Conformed Amended and Restated Certificate of Incorporation of Ambac Financial Group filed with the Secretary of State of the State of Delaware on July 11, 1997. (Filed as Exhibit 4.05 to Ambac Financial Group’s Quarterly Report for the quarter ended September 30, 1997 and incorporated herein by reference.)
3.02	Conformed Copy of the Certificate of Amendment to the Amended and Restated Certificate of Incorporation of Ambac Financial Group, Inc. filed with the Secretary of State of the State of Delaware on May 13, 1998. (Filed as Exhibit 4.04 to the Ambac Financial Group Inc.’s Quarterly Report for the quarter ended June 30, 1998 and incorporated herein by reference.)
3.03+	Conformed Copy of Amendment to the Amended and Restated Certificate of Incorporation of Ambac Financial Group, Inc. filed with the Secretary of State of the State of Delaware on May 28, 2004.
3.04	By-laws of Ambac Financial Group, Inc., as amended through January 27, 2004. (Filed as Exhibit 3.03 to Ambac Financial Group Inc.’s Annual Report on Form 10-K for the year ended December 31, 2003 and incorporated herein by reference.)
4.01	Definitive Engraved Stock Certificate representing shares of Common Stock. (Filed as Exhibit 4.01 to Ambac Financial Group, Inc.’s Annual Report on Form 10-K for the year ended December 31, 1997 and incorporated herein by reference.)
4.02	Indenture, dated as of August 1, 1991, between the Ambac Financial Group, Inc. and The Chase Manhattan Bank (National Association), Trustee. (Filed as Exhibit 4.01 to Ambac Financial Group, Inc.’s Registration Statement on Form S-3 (Reg. No. 33-59290) and incorporated herein by reference.)
4.03	Indenture dated as of August 24, 2001 between Ambac Financial Group, Inc. and the Chase Manhattan Bank as trustee. (Filed as Exhibit 4.1 to Ambac Financial Group, Inc.’s Amendment No. 2 to Registration Statement on Form S-3 (Reg. No. 333-57206) and incorporated herein by reference.)
4.04	Rights Agreement, dated as of January 31, 1996, between Ambac Financial Group, Inc. and Citibank N.A., as Rights Agent, including all exhibits thereto. (Filed as Exhibit 1 to Ambac Financial Group, Inc.’s Registration Statement on Form 8-A dated February 27, 1996 and incorporated herein by reference.)
4.05	Amendment to the Rights Agreement dated as of May 16, 2003 by and between Ambac Financial Group, Inc. and Citibank, N.A., as Rights Agent. (Filed as Exhibit 2 to Amendment No.1 of Ambac Financial Group, Inc.’s Registration Statement on Form 8-A dated May 21, 2003 and incorporated herein by Reference.)

+ Filed herewith.

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4.06	Form of 9.38% Debenture due August 1, 2011. (Filed as Exhibit 4.02 to the Registration Statement on Form S-1 (Reg. No. 33-40385) and incorporated herein by reference.)
4.07	Form of 7.50% Debenture due May 1, 2023. (Filed as Exhibit 4.06 to Ambac Financial Group, Inc.’s Annual Report on Form 10-K for the year ended December 31, 1998 and incorporated herein by reference.)
4.08	Form of 7.00% Debenture due October 17, 2051. (Filed as Exhibit 1 to Ambac Financial Group, Inc.’s Registration Statement on Form 8-A dated October 26, 2001 and incorporated herein by reference.)
4.09	Form of 5.95% Debenture due February 28, 2103 (Filed as Exhibit 2 to Ambac Financial Group, Inc.’s Registration Statement on Form 8-A dated February 26, 2003 and incorporated herein by reference.)
4.10	Form of 5.875% Debentures due March 24, 2103. (Filed as Exhibit 2 to Ambac Financial Group, Inc.’s Registration Statement on Form 8-A dated March 26, 2003 and incorporated herein by reference)
4.11	Indenture dated as of April 22, 2003 between Ambac Financial Group, Inc. and JP Morgan Chase Bank, as trustee. (Filed as Exhibit 4.1 to Ambac Financial Group, Inc.’s Registration Statement on Form S-3 (Reg. No. 333-104758) and incorporated herein by reference.)
10.01*	Second Amended and Restated Employment Agreement dated as of December 2, 1997, between Ambac Financial Group, Inc. and Phillip B. Lassiter. (Filed as Exhibit 10.01 to Ambac Financial Group, Inc.’s Annual Report on Form 10-K for the year ended December 31, 1997 and incorporated herein by reference.)
10.02*	Employment Agreement dated as of January 27, 2004 by and between Ambac Financial Group, Inc. and Robert J. Genader. (Filed as Exhibit 10.02 to Ambac Financial Group, Inc.’s Annual Report on Form 10-K for the year ended December 31, 2003 and incorporated herein by reference.)
10.03*	Employment Agreement dated as of July 19, 2004 by and between Ambac Financial Group, Inc. and William T. McKinnon. (Filed as Exhibit 10.34 to the Quarterly Report on Form 10-Q for the period ended June 30, 2004 and incorporated herein by reference.)
10.04*+	Directors’ Compensation Table. (effective as of January 1, 2004)
10.05*	Ambac Financial Group, Inc. 1991 Stock Incentive Plan, as amended as of December 2, 1997 (Filed as Exhibit 10.02 to Ambac Financial Group, Inc. Annual Report on Form 10-K for the year ended December 31, 1996 and incorporated herein by reference.)
10.06*+	Ambac Financial Group, Inc. 1997 Equity Plan, amended as of July 19, 2004.

+ Filed herewith.

* Management contract or compensatory plan, contract or arrangement required to be filed as an exhibit pursuant to Item 15(c) of Form 10-K.

31

10.07*+	Form of Restricted Stock Unit Award.
10.08*+	Form of Stock Option Award Agreement.
10.09*+	January 2004 Award of Restricted Stock Units to Phillip B. Lassiter.
10.10*	Ambac Financial Group, Inc. 1991 Non-Employee Directors Stock Plan (Filed as Exhibit 10.09 to Ambac Financial Group, Inc.’s Annual Report on Form 10-K for the year ended December 31, 1992 and incorporated herein by reference.)
10.11*+	Ambac Financial Group, Inc. 1997 Non-Employee Directors Equity Plan. (as amended through May 4, 2004.)
10.12*+	Form of Notice of Award of Directors’ Five Year Restricted Stock Units.
10.13*+	Form of Notice of Award of Directors’ Annual Stock Units.
10.14*	Ambac Financial Group, Inc. 1997 Executive Incentive Plan, amended as of January 1, 2000. (Filed as Exhibit 10.23 to Ambac Financial Group, Inc.’s Quarterly Report on Form 10-Q for the period ended June 30, 2000 and incorporated herein by reference.)
10.15*	Ambac Financial Group, Inc. Deferred Compensation Plan for Outside Directors, effective as of December 1, 1993 as amended through October 15, 2002. (Filed as Exhibit 10.07 to Ambac Financial Group, Inc.’s Annual Report of Form 10-K for the year ended December 31, 2002 and incorporated herein by reference.)
10.16*	Ambac Financial Group, Inc. 1997 Equity Plan Senior Officer Deferred Compensation Sub-Plan of the 1997 Equity Plan effective as of October 26, 1999 (Filed as Exhibit 10.27 to Ambac Financial Group, Inc.’s Quarterly Report on Form 10-Q for the period ended September 30, 1999 and incorporated herein by reference.)
10.17*	Form of Amended and Restated Management Retention Agreement dated as of December 2, 1997. (Filed as Exhibit 10.08 to Ambac Financial Group, Inc.’s Annual Report on Form 10-K for the year ended December 31, 1997 and incorporated herein by reference.)
10.18*	The Ambac Financial Group, Inc. Non-Qualified Savings Incentive Plan (effective as of January 1, 1995). (Filed as Exhibit 10.16 to Ambac Financial Group, Inc.’s Quarterly Report on Form 10-Q for the period ended September 30, 1995, and incorporated herein by reference.)
10.19*	Amendment Number 1 to the Ambac Financial Group, Inc. Non-Qualified Savings Incentive Plan effective as of April 30, 1997. (Filed as Exhibit 10.10 to Ambac Financial Group, Inc.’s Annual Report on Form 10-K for the year ended December 31, 1997 and incorporated herein by reference.)

+ Filed herewith.

* Management contract or compensatory plan, contract or arrangement required to be filed as an exhibit pursuant to Item 15(c) of Form 10-K.

32

10.20*	Ambac Financial Group, Inc. Excess Benefits Pension Plan (Amended and Restated as of January 1, 1994) (As amended through October 25, 1995). (Filed as Exhibit 10.17 to Ambac Financial Group, Inc.’ Quarterly Report on Form 10-Q for the period ended September 30, 1995, and incorporated herein by reference.)
10.21*	Amendment Number 1 to the Ambac Financial Group, Inc. Excess Benefits Pension Plan effective as of April 30, 1997. (Filed as Exhibit 10.12 to Ambac Financial Group, Inc.’s Annual Report on Form 10-K for the year ended December 31, 1997 and incorporated herein by reference.)
10.22*	Supplemental Pension Agreement between Ambac Financial Group, Inc. and Philip B. Lassiter dated April 30, 1997. (Filed as Exhibit 10.24 in Ambac Financial Group, Inc.’s Quarterly Report Form 10-Q for the quarter ended June 30, 1997, and incorporated herein by reference.)
10.23*	Supplemental Pension Agreement between Ambac Financial Group and David L. Boyle dated April 30, 1997. (Filed as Exhibit 10.25 in Ambac Financial Group, Inc.’s Quarterly Report Form 10-Q for the quarter ended June 30, 1997, and incorporated herein by reference.)
10.24*	Retirement Agreement between Ambac Financial Group, Inc. and David L. Boyle dated February 15, 2005. (Filed as Exhibit 10.01 to Ambac Financial Group Inc.’s Current Report on Form 8-K filed February 22, 2005 and incorporated herein by reference.)
10.25*	Ambac Financial Group, Inc. Supplemental Pension Plan (Amended and Restated as of January 1, 1995) (As amended through October 25, 1995). (Filed as Exhibit 10.18 to Ambac Financial Group, Inc.’s Quarterly Report on Form 10-Q for the period ended September 30, 1995, and incorporated herein by reference.)
10.26*	Amendment Number 1 to the Ambac Financial Group, Inc. Supplemental Pension Plan effective as of April 30, 1997. (Filed as Exhibit 10.18 to Ambac Financial Group, Inc.’s Annual Report on Form 10-K for the year ended December 31, 1997 and incorporated herein by reference.)
10.27	Lease Agreement, dated as of January 1, 1992 between South Ferry Building Company and Ambac Assurance Corporation. (Filed as Exhibit 10.36 to Ambac Financial Group, Inc.’s Quarterly Report on Form 10-Q for the quarter ended September 30, 1992 and incorporated herein by reference.)
10.28	Amendment to Lease Agreement dated August 1, 1997 between South Ferry Building Company and Ambac Assurance Corporation. (Filed as Exhibit 10.20 to Ambac Financial Group, Inc.’s Annual Report on Form 10-K for the year ended December 31, 1997 and incorporated herein by reference.)

* Management contract or compensatory plan, contract or arrangement required to be filed as an exhibit pursuant to Item 15(c) of Form 10-K.

33

10.29	Amendment to Lease Agreement dated December 23, 2002 between South Ferry Building Company and Ambac Assurance Corporation. (Filed as Exhibit 10.20 to Ambac Financial Group, Inc.’s Annual Report on Form 10-K for the year ended December 31, 2002 and incorporated herein by reference.)
10.30	Tax Settlement Agreement, dated as of March 30, 1993, among Citicorp, Citibank, N.A., Citicorp Financial Guaranty Holdings, Inc., Ambac Financial Group, Inc., Ambac Assurance Corporation, American Municipal Bond Holding Company and Health Care Investment Analysts, Inc. (Filed as Exhibit 10.02 to Ambac Financial Group, Inc.’s Registration Statement on Form S-3 (Registration No. 33-59290) and incorporated herein by reference.)
10.31	Conformed Copy of U.S. $300,000,000 Revolving Credit Agreement, dated as of July 29, 2004 among Ambac Financial Group and Ambac Assurance Corporation as the Borrowers, the banks, financial institutions and other institutional lenders as the Initial Lenders, Barclay’s Bank PLC as the Syndication Agent and Citibank, N.A., as the Administrative Agent. (Filed as Exhibit 10.33 to Ambac Financial Group, Inc.’s Quarterly Report on Form 10-Q for the period ended June 30, 2004 and incorporated herein by reference.)
10.32	Put Option Agreement between Ambac Assurance Corporation and Dutch Harbor Finance Master Trust, on Behalf of its Series Dutch Harbor Finance Sub-Trust I, dated as of December 3, 2001. (Filed as Exhibit 10.27 to Ambac Financial Group, Inc.’s Annual Report on Form 10-K for the year ended December 31, 2001 and incorporated herein by reference.)
10.33	Put Option Agreement between Ambac Assurance Corporation and Dutch Harbor Finance Master Trust, on Behalf of its Series Dutch Harbor Finance Sub-Trust II, dated as of December 3, 2001. (Filed as Exhibit 10.28 to Ambac Financial Group, Inc.’s Annual Report on Form 10-K for the year ended December 31, 2001 and incorporated herein by reference.)
10.34	Put Option Agreement between Ambac Assurance Corporation and Dutch Harbor Finance Master Trust, on Behalf of its Series Dutch Harbor Finance Sub-Trust III, dated as of December 3, 2001. (Filed as Exhibit 10.29 to Ambac Financial Group, Inc.’s Annual Report on Form 10-K for the year ended December 31, 2001 and incorporated herein by reference.)
10.35	Put Option Agreement between Ambac Assurance Corporation and Dutch Harbor Finance Master Trust, on Behalf of its Series Dutch Harbor Finance Sub-Trust IV, dated as of December 3, 2001. (Filed as Exhibit 10.30 to Ambac Financial Group, Inc.’s Annual Report on Form 10-K for the year ended December 31, 2001 and incorporated herein by reference.)
10.36	Put Option Agreement between Ambac Assurance Corporation and Anchorage Finance Master Trust on Behalf of its Series Anchorage Finance Sub-Trust I, dated May 23, 2002. (Filed as Exhibit 10.27 to Ambac Financial Group, Inc.’s Annual Report on Form 10-K for the year ended December 31, 2002 and incorporated herein by reference.)

34

10.37	Put Option Agreement between Ambac Assurance Corporation and Anchorage Finance Master Trust on Behalf of its Series Anchorage Finance Sub-Trust II, dated May 23, 2002. (Filed as Exhibit 10.28 to Ambac Financial Group, Inc.’s Annual Report on Form 10-K for the year ended December 31, 2002 and incorporated herein by reference.)
10.38	Put Option Agreement between Ambac Assurance Corporation and Anchorage Finance Master Trust on Behalf of its Series Anchorage Finance Sub-Trust III, dated May 23, 2002. (Filed as Exhibit 10.29 to Ambac Financial Group, Inc.’s Annual Report on Form 10-K for the year ended December 31, 2002 and incorporated herein by reference.)
10.39	Put Option Agreement between Ambac Assurance Corporation and Anchorage Finance Master Trust on Behalf of its Series Anchorage Finance Sub-Trust IV, dated May 23, 2002. (Filed as Exhibit 10.30 to Ambac Financial Group, Inc.’s Annual Report on Form 10-K for the year ended December 31, 2002 and incorporated herein by reference.)
12.01+	Statement re computation of ratios.
13.01+	Certain portions of Ambac Financial Group, Inc.’s Annual Report to Stockholders for the fiscal year ended December 31, 2004. (Pages 7-9, pages 18-69 and the inside back cover.)
21.01+	List of Subsidiaries of Ambac Financial Group, Inc.
23.01+	Consent of Independent Registered Public Accounting Firm
24.01+	Power of Attorney from Robert J. Genader.
24.02+	Power of Attorney from Michael A. Callen.
24.03+	Power of Attorney from Renso L. Caporali.
24.04+	Power of Attorney from Jill M. Considine.
24.05+	Power of Attorney from Richard Dulude.
24.06+	Power of Attorney from Thomas J. Gandolfo.
24.07+	Power of Attorney from W. Grant Gregory.
24.08+	Power of Attorney from Phillip B. Lassiter.
24.09+	Power of Attorney from Thomas C. Theobald.
24.10+	Power of Attorney from Laura S. Unger.
24.11+	Power of Attorney from Henry D.G. Wallace.
31.1+	Certification of Chief Executive Officer Pursuant to Rules 13a-14(a) and 15d-14(a) Promulgated under the Securities Exchange Act of 1934, as amended.
31.2+	Certification of Chief Financial Officer Pursuant to Rules 13a-14(a) and 15d-14(a) Promulgated under the Securities Exchange Act of 1934, as amended.
32.1++	Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350 as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

+ Filed herewith.

++ Furnished herewith.

35

32.2++	Certification of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350 as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
99.01+	Ambac Assurance Corporation and Subsidiaries Consolidated Financial Statements (with independent auditors’ report thereon) as of December 31, 2004 and 2003.

+ Filed herewith.

++ Furnished herewith.

(b) Reports on Form 8-K:

On January 26, 2005, Ambac Financial Group, Inc. filed a Current Report on Form 8-K with its January 26, 2005 press release containing unaudited financial information and accompanying discussion for the three months ended December 31, 2004 and the year ended December 31, 2004. On February 17, 2005, Ambac Financial Group, Inc. filed a Current Report on Form 8-K to describe ordinary course executive officer compensation actions taken by the Compensation Committee of the Board of Directors of Ambac Financial Group, Inc. On February 22, 2005, Ambac Financial Group, Inc. filed a Current Report on Form 8-K to disclose a retirement agreement, dated February 15, 2005, between Ambac Financial Group, Inc. and David L. Boyle.

36

SIGNATURES

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

	AMBAC FINANCIAL GROUP, INC. (Registrant)
Dated: March 15, 2005	By:	/s/    THOMAS J. GANDOLFO
	Name:	Thomas J. Gandolfo
	Title:	Senior Vice President and Chief Financial Officer

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.

Signature	Title	Date
ROBERT J. GENADER* Robert J. Genader	President and Chief Executive Officer and Director (Principal Executive Officer)	March 15, 2005
/s/    THOMAS J. GANDOLFO         Thomas J. Gandolfo	Senior Vice President and Chief Financial Officer (Principal Financial and Accounting Officer)	March 15, 2005
MICHAEL A. CALLEN* Michael A. Callen	Director	March 15, 2005
RENSO L. CAPORALI* Renso L. Caporali	Director	March 15, 2005
JILL M. CONSIDINE* Jill M. Considine	Director	March 15, 2005
RICHARD DULUDE* Richard Dulude	Director	March 15, 2005
W. GRANT GREGORY* W. Grant Gregory	Director	March 15, 2005
PHILLIP B. LASSITER* Phillip B. Lassiter	Director	March 15, 2005
THOMAS C. THEOBALD* Thomas C. Theobald	Director	March 15, 2005
LAURA S. UNGER* Laura S. Unger	Director	March 15, 2005
HENRY D.G. WALLACE* Henry D.G. Wallace	Director	March 15, 2005

* Thomas J. Gandolfo, by signing his name hereto, does hereby sign this Annual Report on Form 10-K on behalf of each of the directors and officers of the Registrant after whose typed names asterisks appear pursuant to powers of attorney duly executed by such directors and officers and filed with the Securities and Exchange Commission as exhibits to this report.

By:	/s/    THOMAS J. GANDOLFO
	Thomas J. Gandolfo
	Attorney-in-fact

37

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

The Board of Directors

Ambac Financial Group, Inc.:

The audits referred to in our report dated March 2, 2005, with respect to the consolidated financial statements of Ambac Financial Group, Inc., included the related financial statement schedules as of December 31, 2004, and for each of the years in the three-year period ended December 31, 2004, included in this Form 10-K. These financial statement schedules are the responsibility of Ambac Financial Group Inc.’s management. Our responsibility is to express an opinion on these financial statement schedules based on our audits. In our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein. As discussed in Note 2 to the consolidated financial statements, in 2003 Ambac Financial Group, Inc. changed its methods of accounting for variable interest entities and stock-based compensation.

/s/ KPMG LLP

New York, New York

March 2, 2005

AMBAC FINANCIAL GROUP, INC. AND SUBSIDIARIES

SCHEDULE I - SUMMARY OF INVESTMENTS

Other Than Investments in Related Parties

December 31, 2004

(Dollar Amounts in Thousands)

Type of Investment	Amortized Cost		Estimated Fair Value		Amount at which shown in the balance sheet
U.S. government obligations	$	123,499	$	125,321	$	125,321
U.S. agency obligations		829,886		876,242		876,242
Municipal obligations		6,017,682		6,352,190		6,352,190
Mortgage- and asset-backed securities		5,950,293		5,977,551		5,977,551
Corporate obligations		632,303		673,783		673,783
Foreign obligations		217,007		237,873		237,873
Short-term		521,226		521,226		521,226
Other		3,731		4,234		4,234
Total	$	14,295,627	$	14,768,420	$	14,768,420

S-2

AMBAC FINANCIAL GROUP, INC.

SCHEDULE II - CONDENSED FINANCIAL INFORMATION

OF REGISTRANT (PARENT COMPANY ONLY)

Condensed Balance Sheets

December 31, 2004 and 2003

(Dollar Amounts in Thousands Except Share Data)

	2004		2003
ASSETS
Assets:
Cash	$	456	$	323
Investments in subsidiaries		5,746,384		4,972,186
Fixed income securities, at fair value (amortized cost of $0 in 2004 and $16,906 in 2003)		—		17,152
Short-term investments, at cost (approximates fair value)		36,994		36,327
Other investments (cost of $460 in 2004 and $1,021 in 2003)		808		1,106
Current income taxes receivable		33,956		9,961
Deferred income taxes receivable		14,681		24,570
Other assets		26,126		24,523
Total assets	$	5,859,405	$	5,086,148
LIABILITIES AND STOCKHOLDERS’ EQUITY
Liabilities:
Debentures	$	791,839	$	791,775
Note payable to subsidiary		8,942		8,942
Accrued interest payable		6,203		6,203
Other liabilities		27,964		24,670
Total liabilities		834,948		831,590
Stockholders’ equity:
Preferred stock, par value $0.01 per share; authorized shares - 4,000,000; issued and outstanding shares - none		—		—
Common Stock, par value $0.01 per share; authorized shares - 350,000,000 at December 31, 2004 and 200,000,000 at December 31, 2003; issued shares - 108,915,944 at December 31, 2004 and 107,144,148 at December 31, 2003		1,089		1,073
Additional paid-in capital		694,465		606,468
Accumulated other comprehensive income		296,814		266,919
Retained earnings		4,032,089		3,380,098
Common Stock held in treasury at cost, 0 shares at December 31, 2004 and at December 31, 2003		—		—
Total stockholders’ equity		5,024,457		4,254,558
Total liabilities and stockholders’ equity	$	5,859,405	$	5,086,148

S-3

AMBAC FINANCIAL GROUP, INC.

SCHEDULE II - CONDENSED FINANCIAL INFORMATION

OF REGISTRANT (PARENT COMPANY ONLY)

Condensed Statements of Operations

Three Years Ended December 31,

(Dollar Amounts in Thousands)

	2004			2003			2002
Revenues:
Dividend income	$	108,091		$	95,480		$	81,500
Interest and other income		1,824			7,026			3,537
Net realized (losses) gains		(18	)		232			1,482
Total revenues		109,897			102,738			86,519
Expenses:
Interest expense		54,952			54,735			43,295
Operating expenses		10,683			14,562			7,170
Total expenses		65,635			69,297			50,465
Income before income taxes and equity in undistributed net income of subsidiaries		44,262			33,441			36,054
Federal income tax benefit		(22,340	)		(21,714	)		(15,906	)
Income before equity in undistributed net income of subsidiaries		66,602			55,155			51,960
Equity in undistributed net income of subsidiaries		657,949			563,760			380,634
Net income	$	724,551		$	618,915		$	432,594

S-4

AMBAC FINANCIAL GROUP, INC.

SCHEDULE II - CONDENSED FINANCIAL INFORMATION

OF REGISTRANT (PARENT COMPANY ONLY)

Condensed Statements of Stockholders’ Equity

Three Years Ended December 31,

(Dollar Amounts in Thousands)

	2004					2003						2002
Retained Earnings:
Balance at January 1	$	3,380,098				$	2,820,281					$	2,403,473
Net income		724,551		$	724,551		618,915		$	618,915			432,594		$	432,594
Dividends declared – common stock		(50,910	)				(44,739	)					(40,251	)
Exercise of stock options		(21,650	)				(14,359	)					24,465
Balance at December 31	$	4,032,089				$	3,380,098					$	2,820,281
Accumulated Other Comprehensive Income:
Balance at January 1	$	266,919				$	265,427					$	62,476
Unrealized gains (losses) on securities, $15,131, $(10,937), and $339,039, pre-tax, in 2004, 2003 and 2002, respectively) (1)					8,368					(5,923	)					214,943
Gain (loss) on derivative hedges					17,851					4,066						(14,171	)
Foreign currency gain					3,676					3,349						2,179
Other comprehensive income		29,895			29,895		1,492			1,492			202,951			202,951
Total comprehensive income				$	754,446				$	620,407					$	635,545
Balance at December 31	$	296,814				$	266,919					$	265,427
Preferred Stock:
Balance at January 1 and December 31	$	—				$	—					$	—
Common Stock:
Balance at January 1	$	1,073				$	1,062					$	1,060
Issuance of stock		16					11						2
Balance at December 31	$	1,089				$	1,073					$	1,062
Additional Paid-in Capital:
Balance at January 1	$	606,468				$	550,289					$	538,135
Exercise of stock options		48,722					30,445						16,320
Issuance of stock		43,973					30,405						4,287
Capital issuance costs		(4,698	)				(4,671	)					(8,453	)
Balance at December 31	$	694,465				$	606,468					$	550,289
Common Stock Held in Treasury at Cost:
Balance at January 1	$	—				$	(11,880	)				$	(21,456	)
Cost of shares acquired		(51,781	)				(20,247	)					(37,907	)
Shares issued under equity plans		51,781					32,127						47,483
Balance at December 31	$	—				$	—					$	(11,880	)
Total Stockholders’ Equity at December 31	$	5,024,457				$	4,254,558					$	3,625,179

⁽¹⁾ Disclosure of reclassification amount:

	2004		2003			2002
Unrealized holding gains arising during period	$	32,062	$	26,168		$	154,065
Less: reclassification adjustment for net gains (losses) included in net income		23,694		32,091			(60,878	)
Net unrealized gains (losses) on securities	$	8,368	$	(5,923	)	$	214,943

S-5

AMBAC FINANCIAL GROUP, INC.

SCHEDULE II - CONDENSED FINANCIAL INFORMATION

OF REGISTRANT (PARENT COMPANY ONLY)

Condensed Statements of Cash Flows

Three Years Ended December 31,

(Dollar Amounts in Thousands)

	2004			2003			2002
Cash flows from operating activities:
Net income	$	724,551		$	618,915		$	432,594
Adjustments to reconcile net income to net cash provided by (used in) operating activities:
Equity in undistributed net income of Subsidiaries		(657,949	)		(563,760	)		(380,634	)
Net realized losses (gains)		18			(232	)		(1,482	)
(Increase) decrease in current income taxes receivable		(4,283	)		(3,629	)		21,481
(Increase) decrease in other assets		(1,603	)		(8,563	)		2,324
Other, net		10,534			44			4,190
Net cash provided by operating activities		71,268			42,775			78,473
Cash flows from investing activities:
Proceeds from sales of bonds		16,761			10,138			91,602
Proceeds from maturities of bonds		—			200,000			7,404
Proceeds from the sale of Cadre Financial Services		3,676			—			—
Purchases of bonds		—			(317,131	)		(82,865	)
Change in short-term investments		(667	)		3,536			(20,703	)
Other, net		330			(227	)		(14	)
Net cash provided by (used in) investing activities		20,100			(103,684	)		(4,576	)
Cash flows from financing activities:
Dividends paid		(50,910	)		(44,739	)		(40,251	)
Proceeds from issuance of debentures		—			363,188			—
Payment for buyback of debentures		—			(200,000	)		—
Issuance of common stock		43,989			30,416			4,289
Purchases of treasury stock		(51,781	)		(20,247	)		(37,907	)
Proceeds from sale of treasury stock		30,073			32,127			47,483
Contribution to subsidiaries		(62,606	)		(99,724	)		(50,000	)
Net cash provided by (used in) financing activities		(91,235	)		61,021			(76,386	)
Net cash flow		133			112			(2,489	)
Cash at January 1		323			211			2,700
Cash at December 31	$	456		$	323		$	211
Supplemental disclosure of cash flow information:
Cash paid during the year for:
Income taxes	$	175,000		$	175,000		$	159,500
Interest expense on debt	$	55,166		$	54,423		$	47,145

Supplemental disclosure of non-cash financing activities:

Ambac Financial Group, Inc. contributed fixed income securities to Ambac Assurance Corporation amounting to $107,160 in December 2003.

S-6

AMBAC FINANCIAL GROUP, INC.

SCHEDULE II - CONDENSED FINANCIAL INFORMATION

OF REGISTRANT (PARENT COMPANY ONLY)

Note to Condensed Financial Information

The condensed financial information of Ambac Financial Group, Inc. for the years ended December 31, 2004, 2003 and 2002, should be read in conjunction with the consolidated financial statements of Ambac Financial Group, Inc. and Subsidiaries and the notes thereto. Investments in subsidiaries are accounted for using the equity method of accounting.

S-7

AMBAC FINANCIAL GROUP, INC. AND SUBSIDIARIES

SCHEDULE IV - REINSURANCE

(Dollar Amounts in Thousands)

Insurance Premiums Written	Gross Amount		Ceded to Other Companies		Assumed from Other Companies		Net Amount		Percentage of Amount Assumed to Net
Year ended December 31, 2002	$	871,070	$	113,542	$	32,962	$	790,490	4.17	%
Year ended December 31, 2003	$	1,114,445	$	138,146	$	29,258	$	1,005,557	2.91	%
Year ended December 31, 2004	$	1,009,243	$	70,946	$	38,568	$	976,865	3.95	%

S-8

INDEX TO EXHIBITS

Exhibit Number	Description
3.03	Conformed Copy of Amendment to the Amended and Restated Certificate of Incorporation of Ambac Financial Group, Inc. filed with the Secretary of State of the State of Delaware on May 28, 2004.
10.04*	Directors’ Compensation Table. (effective January 1, 2004.)
10.06*	Ambac Financial Group, Inc. 1997 Equity Plan, amended July 19, 2004.
10.07*	Form of Restricted Stock Unit Award.
10.08*	Form of Stock Option Award Agreement.
10.09*	January 2004 Award of Restricted Stock Units to Phillip B. Lassiter.
10.11*	Ambac Financial Group, Inc. 1997 Non-Employee Directors Equity Plan. (as amended through May 4, 2004.)
10.12*	Form of Notice of Award of Directors’ Five Year Restricted Stock Units.
10.13*	Form of Notice of Award of Directors’ Annual Stock Units.
12.01	Statement re computation of ratios.
13.01	Certain portions of Ambac Financial Group, Inc.’s Annual Report to Stockholders for the fiscal year ended December 31, 2004. (Pages 7-9, pages 18-69 and the inside back cover.)
21.01	List of Subsidiaries of Ambac Financial Group, Inc.
23.01	Consent of Independent Registered Public Accounting Firm.
24.01	Power of Attorney from Robert J. Genader.
24.02	Power of Attorney from Michael A. Callen.
24.03	Power of Attorney from Renso L. Caporali.
24.04	Power of Attorney from Jill M. Considine.
24.05	Power of Attorney from Richard Dulude.
24.06	Power of Attorney from Thomas J. Gandolfo.
24.07	Power of Attorney from W. Grant Gregory.
24.08	Power of Attorney from Phillip B. Lassiter.
24.09	Power of Attorney from Thomas C. Theobald.
24.10	Power of Attorney from Laura S. Unger.
24.11	Power of Attorney from Henry D.G. Wallace.

* Management contract or compensatory plan, contract or arrangement required to be filed as an exhibit pursuant to item 15(c) of Form 10-K.

31.1	Certification of Chief Executive Officer Pursuant to Rules 13a-14(a) and 15d-14(a) Promulgated under the Securities Exchange Act of 1934, as amended.
31.2	Certification of Chief Financial Officer Pursuant to Rules 13a-14(a) and 15d-14(a) Promulgated under the Securities Exchange Act of 1934, as amended.
32.1++	Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350 as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2++	Certification of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350 as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
99.01	Ambac Assurance Corporation and Subsidiaries Consolidated Financial Statements (with independent auditors’ report thereon) as of December 31, 2004 and 2003.

++ Furnished herewith.

EX-3.03

EXHIBIT 3.03

CERTIFICATE OF AMENDMENT

TO THE

AMENDED AND RESTATED CERTIFICATE OF INCORPORATION

OF

AMBAC FINANCIAL GROUP, INC.

Ambac Financial Group, Inc., a Delaware corporation (the “Corporation”), hereby certifies to the Secretary of State of the State of Delaware as follows:

1. The name of the Corporation is Ambac Financial Group, Inc. and its Amended and Restated Certificate of Incorporation was filed with the Secretary of State on July 11, 1997.

2. Section 4.1 of Article IV of the Corporation’s Amended and Restated Certificate of Incorporation is hereby amended in its entirety to read as follows:

Section 4.1. Authorized Capital. The total number of shares of all classes of stock that the Corporation shall have authority to issue is 354,000,000, consisting of 350,000,000 shares of common stock, par value $.01 per share (the “Common Stock”) and 4,000,000 shares of preferred stock, par value $.01 per share (the “Preferred Stock”).

3. The foregoing amendment was duly adopted in accordance with the provisions of Section 242 of the General Corporation Law of the State of Delaware.

IN WITNESS WHEREOF, Ambac Financial Group, Inc. has caused this Certificate to be duly executed on this 27th day of May, 2004 in its corporate name and on its behalf by the Chairman, President and Chief Executive Officer and attested by its Secretary, pursuant to Section 103(a) of the General Corporation Law of the State of Delaware.

/s/ Robert J. Genader

Robert J. Genader

President and

Chief Executive Officer

ATTEST:	/s/ Anne G. Gill
	Anne G. Gill
	Secretary

Dated: May 27, 2004

EX-10.04

EXHIBIT 10.04

AMBAC FINANCIAL GROUP, INC.

DIRECTORS COMPENSATION TABLE *

EFFECTIVE AS OF JANUARY 1, 2004

TYPE OF FEE	AMOUNT			MANNER OF PAYMENT
Annual Fees/Awards
•      Annual fee for serving as a director of Ambac Financial Group, Inc.	$	45,000	**	$45,000 payable quarterly in arrears in cash
•      Annual fee for serving as a director of Ambac Assurance Corporation		None
•      Annual fee for chairing a committee of Ambac Financial Group, Inc. or Ambac Assurance Corporation	$	10,000		Payable quarterly in arrears in cash
Meeting Fees
•      Annual fee for serving as a committee member of the Audit Committee	$	10,000		Payable quarterly in arrears in cash
•      Annual fee for serving as a committee member of the Compensation Committee	$	5,000		Payable quarterly in arrears in cash
•      Annual fee for serving as a committee member of the Governance Committee	$	5,000		Payable quarterly in arrears in cash
•      Travel and related expenses incurred in attending a stockholder, board or committee meeting		100% of expenses incurred		Payable in cash promptly upon submission of receipts to the Ambac Financial Group, Inc. Corporate Secretary
Non-Executive Chairman Retainer Fee
•      Annual retainer fee for the Chairman of the Board	$	250,000		Payable in arrears in cash

* Directors who are employees of Ambac Financial Group, Inc. and its affiliates are not paid any fees or other compensation for serving as directors, but are reimbursed for travel and related expenses incurred in attending meetings.

** The cash portion of the annual fee is prorated to reflect service on the Board of less than one full year prior to the relevant annual meeting of stockholders.

AMBAC FINANCIAL GROUP, INC.

DIRECTORS COMPENSATION TABLE

TO BECOME EFFECTIVE AS OF MAY 4, 2004

(CONTINUED PAGE 2 OF 2)

TYPE OF FEE	AMOUNT	MANNER OF PAYMENT
Stock Awards
•      Annual Award of Restricted Units of Common Stock (RSUs)	Value of $60,000 RSUs on date of the Annual Meeting	•      The value of $60,000 of RSUs will be awarded annually on the date of the annual meeting of stockholders. The number of RSUs shall be equal to $60,000 divided by the average of the high and low selling price of Ambac’s Common Stock on the NYSE on the date of the Annual Meeting. •      The RSUs vest on the first anniversary of the grant
•      Five-year Award of RSUs	Value of $210,000 RSUs on date of Annual Meeting (only granted once every 5 years)	•      The value of $210,000 of RSUs are awarded on the date of the annual meeting of stockholders coincident with, or first succeeding the director’s election to the Ambac Financial Group, Inc. Board. The number of RSUs shall be equal to $210,000 divided by the average of the high and low selling price of Ambac’s Common Stock on the NYSE on the date of the Annual Meeting. •      These RSUs vest on the date of the annual meeting held in the fifth year following the date of grant •      Assuming the director remains on the Board following vesting, he or she will be awarded an additional $210,000 in RSUs •      RSUs are awarded under the 1997 Non-Employee Directors Plan, as amended

OTHER BENEFITS	DESCRIPTION
•      Deferred compensation	Under the Deferred Compensation Plan for Outside Directors and Eligible Senior Officers, non-employee directors may elect to defer all or part of their director compensation (including both annual and meeting fees) that is paid in cash
•      Health and welfare	Each non-employee director is permitted to enroll (without paying any premium) in the Ambac Financial Group, Inc. medical and dental plan and is eligible to receive a $50,000 term life insurance policy (without paying any premium)

EX-10.06

EXHIBIT 10.06

AMBAC 1997 EQUITY PLAN

(amended as of July 19, 2004)

1. Purposes

The purposes of the Ambac 1997 Equity Plan (the “Plan”) are to attract, retain and motivate key employees of the Company, to compensate them for their contributions to the growth and profits of the Company and to encourage them to own Common Stock.

2. Definitions

For purposes of the Plan, the following terms shall be defined as follows:

“Administrator” means the individual or individuals to whom the Committee delegates authority under the Plan in accordance with Section 3(d).

“Ambac” means Ambac Financial Group, Inc., a Delaware corporation.

“Award” means an award made pursuant to the terms of the Plan to an Eligible Individual in the form of Stock Options, Stock Appreciation Rights, Stock Awards, Restricted Stock Units, Performance Units or Other Awards.

“Award Agreement” means a written document approved in accordance with Section 3 which sets forth the terms and conditions of the Award to the Participant. An Award Agreement may be in the form of a certificate issued by Ambac or one of its Subsidiaries which is executed by an officer on behalf of Ambac or such Subsidiary but does not require the signature of the Participant.

“Board” means the Board of Directors of the Company.

“Code” means the Internal Revenue Code of 1986, as amended, and the applicable rulings and regulations (including any proposed regulations) thereunder.

“Committee” means the Compensation Committee of the Board, any successor committee thereto or any other committee appointed from time to time by the Board to administer the Plan. The Committee shall consist of at least two individuals and shall serve at the pleasure of the Board.

“Common Stock” means the Common Stock, par value $.01 per share, of the Company.

“Company” means Ambac and its Subsidiaries.

“Eligible Individuals” means the individuals described in Section 6 who are eligible for Awards under the Plan.

“Exchange Act” means the Securities Exchange Act of 1934, as amended, and the applicable rulings and regulations thereunder.

“Excluded Individual” means (i) any individual who is designated by the Company at the time of hire as not eligible to participate in the Plan or (ii) any individual who is treated or designated by the Company as an independent contractor, leased employee (including, without limitation, a “leased employee” as defined in Section 414(n) of the Code) or consultant. Excluded Individuals are not eligible to participate in or receive benefits under the Plan. If any Excluded Individual pursuant to the preceding clauses (i) or (ii) shall be determined by a court or federal, state or local regulatory or administrative authority to have served as a common law employee of the Company, such determination shall not alter such person’s status as an Excluded Individual for purposes of the Plan.

“Fair Market Value” means, with respect to a share of Common Stock, the fair market value thereof as of the relevant date of determination, as determined in accordance with a valuation methodology approved by the Committee. In the absence of any alternative valuation methodology approved by the Committee, the Fair Market Value of a share of Common Stock shall equal the average of the highest and the lowest quoted selling price of a share of Common Stock as reported on the composite tape for securities listed on the New York Stock Exchange, or such other national securities exchange as may be designated by the Committee, or, in the event that the Common Stock is not listed for trading on a national securities exchange but is quoted on an automated system, on such automated system, in any such case on the valuation date (or, if there were no sales on the valuation date, the average of the highest and the lowest quoted selling prices as reported on said composite tape or automated system for the most recent day during which a sale occurred).

“Incentive Stock Option” means a Stock Option which is an “incentive stock option” within the meaning of Section 422 of the Code and designated by the Committee as an Incentive Stock Option in an Award Agreement.

“Nonqualified Stock Option” means a Stock Option which is not an Incentive Stock Option.

“Other Award” means any other form of award authorized under Section 13 of the Plan.

“Participant” means an Eligible Individual to whom an Award has been granted under the Plan.

“Performance Unit” means a performance unit granted to an Eligible Individual pursuant to Section 12 hereof.

“Predecessor Plan” means the AMBAC Inc. 1991 Stock Incentive Plan, as amended.

“Restoration Option” means a Stock Option that is awarded upon the exercise of a Stock Option earlier awarded under the Plan or the Predecessor Plan (an “Underlying Option”) for which the exercise price is paid in whole or in party by tendering shares of Common Stock owned by the Participant, where such Restoration Option (i) covers a number of shares of Common Stock no greater than the number of shares tendered in payment of the exercise price of the Underlying Option plus the number of shares withheld to pay taxes arising upon such exercise, (ii) the expiration date of the Restoration Option is no later than the expiration date of the Underlying Option and (iii) the exercise price per share of the Restoration Option is no less than the Fair Market Value per share of Common Stock on the date of exercise of the Underlying Option.

“Restricted Stock Unit” means a restricted stock unit granted to an Eligible Individual pursuant to Section 11 hereof.

“Stock Appreciation Right” means a right to receive all or some portion of the appreciation on shares of Common Stock granted to an Eligible Individual pursuant to Section 9 hereof.

“Stock Award” means a share of Common Stock granted to an Eligible Individual for no consideration other than the provision of services or offer for sale to an Eligible Employee at a purchase price determined by the Committee, in either case pursuant to Section 10 hereof.

“Stock Option” means an Award to purchase shares of Common Stock granted to an Eligible Individual pursuant to Section 8 hereof, which Award may be either an Incentive Stock Option or a Nonqualified Stock Option.

“Subsidiary” means (i) a corporation or other entity with respect to which Ambac, directly or indirectly, has the power, whether through the ownership of voting securities, by contract or otherwise, to elect at least

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a majority of the members of such corporation’s board of directors or analogous governing body, or (ii) any other corporation or other entity in which Ambac, directly or indirectly, has an equity or similar interest and which the Committee designates as a Subsidiary for purposes of the Plan.

“Substitute Award” means an Award granted in connection with a corporate transaction, such as a merger, combination, consolidation or acquisition of property or stock upon assumption of, or in substitution for, outstanding awards previously granted by a company or other entity.

3. Administration of the Plan

(a) Power and Authority of the Committee. The Plan shall be administered by the Committee, which shall have full power and authority, subject to the express provisions hereof:

(i) to select Participants from the Eligible Individuals;

(ii) to make Awards in accordance with the Plan;

(iii) to determine the number of shares of Common Stock subject to each Award or the cash amount payable in connection with an Award;

(iv) to determine the terms and conditions of each Award, including, without limitation, those related to vesting, forfeiture, payment and exercisability, and the effect, if any, of a Participant’s termination of employment with the Company, and including the authority to amend the terms and conditions of an Award after the granting thereof to a Participant in a manner that is not, without the consent of the Participant, prejudicial to the rights of such Participant in such Award;

(v) to specify and approve the provisions of the Award Agreements delivered to Participants in connection with their Awards;

(vi) to construe and interpret any Award Agreement delivered under the Plan;

(vii) to prescribe, amend and rescind rules and procedures relating to the Plan;

(viii) to vary the terms of Awards to take account of tax, securities law and other regulatory requirements of foreign jurisdictions;

(ix) subject to the provisions of the Plan and subject to such additional limitations and restrictions as the Committee may impose, to delegate to one or more officers of the Company some or all of its authority under the Plan;

(x) to employ such legal counsel, independent auditors and consultants as it deems desirable for the administration of the Plan and to rely upon any opinion or computation received therefrom; and

(xi) to make all other determinations and to formulate such procedures as may be necessary or advisable for the administration of the Plan.

(b) Plan Construction and Interpretation. The Committee shall have full power and authority, subject to the express provisions hereof, to construe and interpret the Plan.

(c) Determinations of Committee Final and Binding. All determinations by the Committee in carrying out and administering the Plan and in construing and interpreting the Plan shall be final, binding and conclusive for all purposes and upon all persons interested herein.

(d) Delegation of Authority. The Committee may, but need not, from time to time delegate some or all of its authority under the Plan to an Administrator consisting of one or more members of the Committee or

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of one or more officers of the Company; provided, however, that the Committee may not delegate its authority (i) to make Awards to Eligible Individuals who are officers of the Company who are delegated authority by the Committee hereunder, or (ii) under Section 16 of the Plan. Any delegation hereunder shall be subject to the restrictions and limits that the Committee specifies at the time of such delegation or thereafter. Nothing in the Plan shall be construed as obligating the Committee to delegate authority to an Administrator, and the Committee may at any time rescind the authority delegated to an Administrator appointed hereunder or appoint a new Administrator. At all times, the Administrator appointed under this Section 3(d) shall serve in such capacity at the pleasure of the Committee. Any action undertaken by the Administrator in accordance with the Committee’s delegation of authority shall have the same force and effect as if undertaken directly by the Committee, and any reference in the Plan to the Committee shall, to the extent consistent with the terms and limitations of such delegation, be deemed to include a reference to the Administrator.

(e) Liability of Committee. No member of the Committee shall be liable for any action nor determination made in good faith, and the members of the Committee shall be entitled to indemnification and reimbursement in the manner provided in Ambac’s Certificate of Incorporation and the By-laws as they may be amended from time to time. In the performance of its responsibilities with respect to the Plan, the Committee shall be entitled to rely upon information and advice furnished by the Company’s officers, the Company’s accountants, the Company’s counsel and any other party the Committee deems necessary, and no member of the Committee shall be liable for any action taken or not taken in reliance upon any such advice.

(f) Action by the Board. Anything in the Plan to the contrary notwithstanding, any authority or responsibility which, under the terms of the Plan, may be exercised by the Committee may alternatively be exercised by the Board.

4. Effective Date and Term

The Plan became effective on May 15, 1997 after approval by the Board and the stockholders of Ambac in 1997. Upon recommendation by the Board, the stockholders of Ambac adopted certain amendments to the Plan, including extending the term of the Plan by seven years to May 6, 2011

5. Shares of Common Stock Subject to the Plan

(a) General. Subject to adjustment as provided in Section 15(b) hereof, the number of shares of Common Stock that may be issued pursuant to Awards under the Plan (the “Section 5 Limit”) shall not exceed, in the aggregate:

(I) 14,000,000 shares; plus

(II) the number of shares of Common Stock that remain available for issuance under the Predecessor Plan as of the date this Plan is approved by the stockholders of the Company (increased by any shares of Common Stock subject to any award (or portion thereof) outstanding under the Predecessor Plan on such date which lapses, expires or is otherwise terminated without the issuance of such shares or is settled by the delivery of consideration other than shares).

Shares issued under this Plan may be either authorized but unissued shares, treasury shares or any combination thereof.

(b) Rules Applicable to Determining Shares Available for Issuance. For purposes of determining the number of shares of Common Stock that remain available for issuance, the following shares shall be added back to the Section 5 Limit and again be available for Awards:

(x) The number of shares tendered to pay the exercise price of a Stock Option or other Award; and

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(y) The number of shares withheld from any Award to satisfy a Participant’s tax withholding obligations or, if applicable, to pay the exercise price of a Stock Option or other Award.

In addition, any shares underlying Substitute Awards shall not be counted against the Section 5 Limit and shall not be subject to Section 5(c) below.

(c) Special Limits. Anything to the contrary in Section 5(a) above notwithstanding, but subject to Section 15(b) below, the following special limits shall apply to shares of Common Stock available for Awards under the Plan:

(i) The maximum number of shares that may be issued in the form of Stock Awards, or issued upon settlement of Restricted Stock Units or Other Awards, shall equal 4,000,000 shares, of which no more than a number of shares equal to 10% of the Section 5 Limit shall be in the form of Other Awards, provided, however, that any such Stock Awards, Restricted Stock Units or Other Awards that are issued in lieu of cash compensation that otherwise would be paid to a Participant, or in satisfaction of any other obligation owed by the Company to a Participant, shall not be counted against such limitation; and

(ii) The maximum number of shares of Common Stock that may be subject to Stock Options or Stock Appreciation Rights granted to any Eligible Individual in any fiscal year of the Company shall equal 600,000 shares plus any shares which were available under this Section 5(c) (ii) for Awards of Stock Options or Stock Appreciation Rights to such Eligible Individual in any prior fiscal year but which were not covered by such Awards.

(d) No Further Awards under Predecessor Plan. From and after the date this Plan is approved by the stockholders of the Company, no further awards shall be made under the Predecessor Plan.

6. Eligible Individuals

Awards may be granted by the Committee to individuals (“Eligible Individuals”) who are: (i) officers or other key employees of the Company; (ii) employees of joint ventures, partnerships or similar business organizations in which the Company has a direct or indirect equity interest; and individuals who provide services to any joint ventures or business organizations in which the Company may participate in the future. Excluded Individuals are not eligible to receive Awards under the Plan. Members of the Committee will not be eligible to receive Awards under the Plan. An individual’s status as an Administrator will not affect his or her eligibility to participate in the Plan.

7. Awards in General

(a) Types of Award and Award Agreement. Awards under the Plan may consist of Stock Options, Stock Appreciation Rights, Stock Awards, Restricted Stock Units, Performance Units or Other Awards. Any Award described in Sections 8 through 13 of the Plan may be granted singly or in combination or tandem with any other Award, as the Committee may determine. Awards may be made in combination with, in replacement of, or as alternatives to grants of rights under any other employee compensation plan of the Company, including the plan of any acquired entity, or may be granted in satisfaction of the Company’s obligations under any such plan.

(b) Terms Set Forth in Award Agreement. The terms and provisions of an Award shall be set forth in a written Award Agreement approved by the Committee and delivered or made available to the Participant as soon as practicable following the date of the Award. The vesting, exercisability, payment and other restrictions applicable to an Award (which may include, without limitation, restrictions on transferability or provision for mandatory resale to the Company) shall be determined by the Committee and set forth in the applicable Award Agreement. Notwithstanding the foregoing, the Committee may accelerate (i) the vesting or payment of any Award, (ii) the lapse of restrictions on any Award or (iii) the date on which any Stock Option, Stock Appreciation Right or other Award first becomes exercisable.

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(c) Termination of Employment and Change in Control. The Committee shall also have full authority to determine and specify in the applicable Award Agreement the effect, if any, that a Participant’s termination of employment for any reason will have on the vesting, exercisability, payment or lapse of restrictions applicable to an Award. The date of a Participant’s termination of employment for any reason shall be determined in the sole discretion of the Committee. Similarly, the Committee shall have full authority to determine the effect, if any, of a change in control of Ambac on the vesting, exercisability, payment or lapse of restrictions applicable to an Award, which effect may be specified in the applicable Award Agreement or determined at a subsequent time.

(d) Dividends and Dividend Equivalents. The Committee may provide Participants with the right to receive dividends or payments equivalent to dividends or interest with respect to an outstanding Awards, which payments can either be paid currently or deemed to have been reinvested in shares of Common Stock, and can be made in Common Stock, cash or a combination thereof, as the Committee shall determine.

8. Stock Options

(a) Terms of Stock Options Generally. A Stock Option shall entitle the Participant to whom the Stock Option was granted to purchase a specified number of shares of Common Stock during a specified period at a price that is determined in accordance with Section 8(b) below. Stock Options may be either Nonqualified Stock Options or Incentive Stock Options. The Committee will fix the vesting and exercisability conditions applicable to a Stock Option, provided that no Stock Option shall vest sooner than one year from the date of grant (subject to early vesting, if so provided by the Committee, upon death, disability, termination of employment or a change in control of the Company.

(b) Exercise Price. The exercise price per share of Common Stock purchasable under a Stock Option shall be fixed by the Committee at the time of grant or, alternatively, shall be determined by a method specified by the Committee at the time of grant; provided, however, that the exercise price per share shall be no less than 100% of the Fair Market Value per share on the date of grant (or it the exercise price is not fixed on the date of grant, then on such date as the exercise price is fixed); and provided further, that, except as provided in Section 15(b) below, the exercise price per share of Common Stock applicable to a Stock Option may not be adjusted or amended, including by means of amendment, cancellation or the replacement of such Stock Option with a subsequently awarded Stock Option. Notwithstanding the foregoing, the exercise price per share of a Stock Option that is a Substitute Award may be less than the Fair Market Value per share on the date of award, provided that the excess of:

(i) the aggregate Fair Market Value (as of the date such Substitute Award is granted) of the shares of Common Stock subject to the Substitute Award, over

(ii) the aggregate exercise price thereof,

does not exceed the excess of:

(iii) the aggregate fair market value (as of the time immediately preceding the transaction giving rise to the Substitute Award, such fair market value to be determined by the Committee) of the shares of the predecessor entity that were subject to the award assumed or substituted for by the Company, over

(iv) the aggregate exercise price of such shares.

(c) Option Term. The term of each Stock Option shall be fixed by the Committee and shall not exceed ten years from the date of grant.

(d) Method of Exercise. Subject to the provisions of the applicable Award Agreement, the exercise price of a Stock Option may be paid in cash or previously owned shares or a combination thereof and, if the applicable Award Agreement so provides or the Committee otherwise so determines, in whole or in part

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through the withholding of shares subject to the Stock Option with a value equal to the exercise price. In accordance with the rules and procedures established by the Committee for this purpose, the Stock Option may also be exercised through a “cashless exercise” procedure approved by the Committee involving a broker or dealer approved by the Committee, that affords Participants the opportunity to sell immediately some or all of the shares underlying the exercised portion of the Stock Option in order to generate sufficient cash to pay the Stock Option exercise price and/or to satisfy withholding tax obligations related to the Stock Option.

9. Stock Appreciation Rights

(a) General. A Stock Appreciation Right shall entitle a Participant to receive, upon satisfaction of the conditions to the payment specified in the applicable Award Agreement, an amount equal to the excess, if any, of the Fair Market Value on the exercise date of the number of shares of Common Stock for which the Stock Appreciation Right is exercised, over the exercise price for such Stock Appreciation Right specified in the applicable Award Agreement. The exercise price per share of Common Stock covered by a Stock Appreciation Right shall be fixed by the Committee at the time of grant or, alternatively, shall be determined by a method specified by the Committee at the time of grant; provided, however, that, except as provided in Section 9(b) below, the exercise price per share shall be no less than 100% of the Fair Market Value per share on the date of grant (or if the exercise price is not fixed on the date of grant, then on such date as the exercise price is fixed); and provided further, that, except as provided in Section 15(b) below, the exercise price per share of Common Stock subject to a Stock Appreciation Right may not be adjusted or amended, including by means of amendment, cancellation or the replacement of such Stock Appreciation Right with a subsequently awarded Stock Appreciation Right. Notwithstanding the foregoing, the exercise price per share of a Stock Appreciation Right that is a Substitute Award may be less than the Fair Market Value per share on the date of award, provided, that such exercise price is not less than the minimum exercise price that would be permitted for an equivalent Stock Option as determined in accordance with Section 8(b) above. At the sole discretion of the Committee, payments to a Participant upon exercise of a Stock Appreciation Right may be made in cash, in shares of Common Stock having an aggregate Fair Market Value as of the date of exercise equal to such amount, or in a combination of cash and shares having an aggregate value as of the date of exercise equal to such amount.

(b) Stock Appreciation Rights in Tandem with Stock Options. A Stock Appreciation Right may be granted alone or in addition to other Awards, or in tandem with a Stock Option. A Stock Appreciation Right granted in tandem with a Stock Option may be granted either at the same time as such Stock Option or subsequent thereto. If granted in tandem with a Stock Option, a Stock Appreciation Right shall cover the same number of shares of Common Stock as covered by the Stock Option (or such lesser number of shares as the Committee may determine) and shall be exercisable only at such time or times and to the extent the related Stock Option shall be exercisable, and shall have the same term and exercise price as the related Stock Option (which, in the case of a Stock Appreciation Right granted after the grant of the related Stock Option, may be less than the Fair Market Value per share on the date of grant of the tandem Stock Appreciation Right). Upon exercise of a Stock Appreciation Right granted in tandem with a Stock Option, the related Stock Option shall be canceled automatically to the extent of the number of shares covered by such exercise; conversely, if the related Stock Option is exercised as to some or all of the shares covered by the tandem grant, the tandem Stock Appreciation Right shall be canceled automatically to the extent of the number of shares covered by the Stock Option exercise.

10. Stock Awards

(a) General. A Stock Award shall consist of one or more shares of Common Stock granted to a Participant for no consideration other than the provision of services (or, if required by applicable law in the reasonable judgment of the Company, for payment of the par value of such shares). Stock Awards shall be subject to such restrictions (if any) on transfer or other incidents of ownership for such periods of time, and shall be subject to such conditions of vesting, as the Committee may determine and as shall be set forth in the applicable Award Agreement.

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(b) Distributions. Any shares of Common Stock or other securities of the Company received by a Participant to whom a Stock Award has been granted as a result of a stock distribution to holders of Common Stock or as a stock dividend on Common Stock shall be subject to the same terms, conditions and restrictions as such Stock Award.

11. Restricted Stock Units

An Award of Restricted Stock Units shall consist of a grant of units, each of which represents the right of the Participant to receive one share of Common Stock, subject to the terms and conditions established by the Committee in connection with the Award and set forth in the applicable Award Agreement. Upon satisfaction of the conditions to vesting and payment specified in the applicable Award Agreement, Restricted Stock Units will be payable in Common Stock or, if the Committee so determines, in cash, equal to the Fair Market Value of the shares subject to such Restricted Stock Units. Restricted Stock Units that are granted to an Eligible Individual in respect of corporate performance shall vest no sooner than one year from the date of grant, and Restricted Stock Units that are granted in connection with hiring or retention arrangements between the Company and a Participant shall vest no sooner than three years from the date of grant (subject, in either case, to early vesting, if so provided by the Committee, upon death, disability, termination of employment or a change in control of the Company).

12. Performance Units

Performance units may be granted as fixed or variable share- or dollar-denominated units subject to such conditions of vesting and time of payment as the Committee may determine and as shall be set forth in the applicable Award Agreement relating to such Performance Units. Performance Units may be paid in Common Stock, cash or a combination of Common Stock and cash, as the Committee may determine.

13. Other Awards

The Committee shall have the authority to specify the terms and provisions of other forms of equity-based or equity-related Awards not described above which the Committee determines to be consistent with the purpose of the Plan and the interests of the Company, which Awards may provide for cash payments based in whole or in part on the value or future value of Common Stock, for the acquisition or future acquisition of Common Stock, or any combination thereof. Other Awards shall also include cash payments (including the cash payment of dividend equivalents) under the Plan which may be based on one or more criteria determined by the Committee which are unrelated to the value of Common Stock and which may be granted in tandem with, or independent of, other Awards under the Plan.

14. Certain Restrictions

(a) Transfers. Unless the Committee determines otherwise, no Award shall be transferable other than by will or by the laws of descent and distribution or pursuant to a qualified domestic relations order; provided, however, that the Committee may, in its discretion and subject to such terms and conditions as it shall specify, permit the transfer of an Award for no consideration to a Participant’s family members or to one or more trusts or partnerships established in whole or in part for the benefit of one or more of such family members (collectively, “Permitted Transferees”). Any Award transferred to a Permitted Transferee shall be further transferable only by will or the laws of descent and distribution or, for no consideration, to another Permitted Transferee of the Participant. The Committee may in its discretion permit transfers of Awards other than those contemplated by this Section.

(b) Exercise. During the lifetime of the Participant, a Stock Option, Stock Appreciation Right or similar-type Other Award shall be exercisable only by the Participant or by a Permitted Transferee to whom such Stock Option, Stock Appreciation Right or Other Award has been transferred in accordance with Section 14(a).

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15. Recapitalization or Reorganization

(a) Authority of the Company and Stockholders. The existence of the Plan, the Award Agreements and the Awards granted hereunder shall not affect or restrict in any way the right or power of the Company or the stockholders of the Company to make or authorize any adjustment, recapitalization, reorganization or other change in the Company’s capital structure or its business, any merger or consolidation of the Company, any issue of stock or of options, warrants or rights to purchase stock or of bonds, debentures, preferred or prior preference stocks whose rights are superior to or affect the Common Stock or the rights thereof or which are convertible into or exchangeable for Common Stock, or the dissolution or liquidation of the Company, or any sale or transfer of all or any part of its assets or business, or any other corporate act or proceeding, whether of a similar character or otherwise.

(b) Change in Capitalization. Notwithstanding any provision of the Plan or any Award Agreement, the number and kind of shares authorized for issuance under Section 5(a) above, including the maximum number of shares available under the special limits provided for in Section 5(c) above, may be equitably adjusted in the sole discretion of the Committee in the event of a stock split, stock dividend, recapitalization, reorganization, merger, consolidation, extraordinary dividend, split-up, spin-off, combination, exchange of shares, warrants or rights offering to purchase Common Stock at a price substantially below Fair Market Value or other similar corporate event affecting the Common Stock in order to preserve, but not increase, the benefits or potential benefits intended to be made available under the Plan. In addition, upon the occurrence of any of the foregoing events, the number of outstanding Awards and the number and kind of shares subject to any outstanding Award and the purchase price per share, if any, under any outstanding Award may be equitably adjusted (including by payment of cash to a Participant) in the sole discretion of the Committee in order to preserve the benefits or potential benefits intended to be made available to Participants granted Awards. Such adjustments shall be made by the Committee, whose determination as to what adjustments shall be made, and the extent thereof, shall be final. Unless otherwise determined by the Committee, such adjusted Awards shall be subject to the same vesting schedule and restrictions to which the underlying Award is subject.

16. Amendments

The Board or Committee may at any time and from time to time alter, amend, suspend or amend the Plan in whole or in part; provided, however, that any amendment which under the requirements of any applicable law or stock exchange rule must be approved by the stockholders of the Company shall not be effective unless and until such stockholder approval has been obtained in compliance with such law or rule; and provided further, that, except as contemplated by Section 15(b) above, the Board or Committee may not, without the approval of the Company’s stockholders, increase the maximum number of shares issuable under the Plan or reduce the exercise price of a Stock Option or Stock Appreciation Right. No termination or amendment of the Plan may, without the consent of the Participant to whom an Award has been granted, adversely affect the rights of such Participant under such Award. Notwithstanding any provision herein to the contrary, the Board or Committee shall have broad authority to amend the Plan or any Award under the Plan to take into account changes in applicable tax laws, securities laws, accounting rules and other applicable state and federal laws.

17. Miscellaneous

(a) Tax Withholding. The Company may require any individual entitled to receive a payment in respect of an Award to remit to the Company, prior to such payment, an amount sufficient to satisfy any Federal, state or local tax withholding requirements. The Company shall also have the right to deduct from all cash payments made pursuant to or in connection with any Award any Federal, state or local taxes required to be withheld with respect to such payments. The Company will not exercise this right in circumstances where the participant’s employment is located outside of the United States at the time of exercise or settlement, the participant is subject to income tax in that foreign

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jurisdiction, and there is no legal requirement on the Company to withhold tax and remit it to the revenue authority in that foreign jurisdiction. In the case of an Award payable in shares of Common Stock, the Company may permit such individual to satisfy, in whole or in part, such obligation to remit taxes by directing the Company to withhold shares of Common Stock that would otherwise be received by such individual, pursuant to such rules as the Committee may establish from time to time.

(b) No Right to Grants or Employment. No Eligible Individual or Participant shall have any claim or right to receive grants of Awards under the Plan. Nothing in the Plan or in any Award or Award Agreement shall confer upon any employee of the Company any right to continued employment with the Company or interfere in any way with the right of the Company to terminate the employment of any of its employees at any time, with or without cause.

(c) Other Compensation. Nothing in this Plan shall preclude or limit the ability of the Company to pay any compensation to a Participant under the Company’s other compensation and benefit plans and programs.

(d) Other Employee Benefit Plans. Payments received by a Participant under any Award made pursuant to the Plan shall not be included in, nor have any effect on, the determination of benefits under any other employee benefit plan or similar arrangement provided by the Company, unless otherwise specifically provided for under the terms of such plan or arrangement or by the Committee.

(e) Unfunded Plan. The Plan is intended to constitute an unfunded plan for incentive compensation. Prior to the payment or settlement of any Award, nothing contained herein shall give any Participant any rights that are greater than those of a general creditor of the Company. In its sole discretion, the Committee may authorize the creation of trusts or other arrangements to meet the obligations created under the Plan to deliver Common Stock or payments in lieu thereof with respect to Awards hereunder.

(f) Securities Law Restrictions. The Committee may require each Eligible Individual purchasing or acquiring shares of Common Stock pursuant to a Stock Option or other Award under the Plan to represent to and agree with the Company in writing that such Eligible Individual is acquiring the shares for investment and not with a view to the distribution thereof. All certificates for shares of Common Stock delivered under the Plan shall be subject to such stock-transfer orders and other restrictions as the Committee may deem advisable under the rules, regulations, and other requirements of the Securities and Exchange Commission, any exchange upon which the Common Stock is then listed, and any applicable federal or state securities law, and the Committee may cause a legend or legends to be put on any such certificates to make appropriate reference to such restrictions. No shares of Common Stock shall be issued hereunder unless the Company shall have determined that such issuance is in compliance with, or pursuant to an exemption from, all applicable federal and state securities laws.

(g) Compliance with Rule 16b-3. Notwithstanding anything contained in the Plan or in any Award Agreement to the contrary, if the consummation of any transaction under the Plan would result in the possible imposition of liability on a Participant pursuant to Section 16(b) of the Exchange Act, the Committee shall have the right, in its sole discretion, but shall not be obligated, to defer such transaction or the effectiveness of such action to the extent necessary to avoid such liability, but in no event for a period longer than six months.

(h) Award Agreement. In the event of any conflict or inconsistency between the Plan and any Award Agreement, the Plan shall govern, and the Award Agreement shall be interpreted to minimize or eliminate any such conflict or inconsistency.

(i) Expenses. The costs and expenses of administering the Plan shall be borne by the Company.

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(j) Application of Funds. The proceeds received from the Company from the sale of Common Stock or other securities pursuant to Awards will be used for general corporate purposes.

(k) Applicable Law. Except as to matters of federal law, the Plan and all actions taken thereunder shall be governed by and construed in accordance with the laws of the State of Delaware without giving effect to conflicts of law principles.

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EX-10.07

EXHIBIT 10.07

AMBAC FINANCIAL GROUP, INC.

1997 EQUITY PLAN

FORM OF NOTICE OF AWARD OF RESTRICTED STOCK UNITS

Ambac Financial Group, Inc., a Delaware corporation and its Subsidiaries (referred to herein as either the “Company” or “Ambac”), have adopted the Ambac 1997 Equity Plan (the “Plan”), for the purposes of providing an incentive to selected employees of the Company and its affiliates to remain in its employ and to increase their interest in the success of the Company. The Company pursues these goals by providing selected employees with opportunities through the Plan to increase their proprietary interest in the Company and to receive compensation based upon the Company’s success.

This 2005 Restricted Stock Unit notice of award (the “Notice of Award”) sets forth the terms and conditions of the restricted stock units that have been granted under the Plan to the individual identified on Annex A (the “Participant”). This Notice of Award sets forth the number of restricted stock units that the Participant will receive, the date of grant and the applicable vesting schedule.

1. Incorporation of Plan Terms.

This Notice of Award and the restricted stock units granted hereby are subject to the Plan, the terms of which are incorporated herein by reference. If there is any conflict or inconsistency between the Plan and this Notice of Award, the Plan shall govern. Capitalized terms used in this Notice of Award without definition shall have the meanings assigned to them in the Plan. A copy of the Plan is available on Ambac’s intranet site.

2. Grant of Restricted Stock Units.

Subject to the conditions contained herein and in the Plan, the Company grants to the Participant, as of the date of grant indicated on Annex A (the “Date of Grant”), the number of restricted stock units (the “RSUs”) specified on Annex A.

3. Terms and Conditions of the RSUs.

The RSUs shall have the following terms and conditions:

(a) General. Each RSU shall represent the unsecured promise of the Company to transfer to the Participant, on the settlement date of such RSU and subject to the terms and conditions set forth in this Notice of Award, one share of the Company’s common stock, par value $0.01 per share (the “Common Stock”).

(b) Vesting.

(i) Normal Vesting. The RSUs will ordinarily vest in accordance with the vesting schedule set forth on Annex A hereto.

(ii) Accelerated Vesting. Notwithstanding Section 3(b)(i), any RSUs that have not previously vested shall vest in full upon the termination of the Participant’s employment with the Company and its Subsidiaries by reason of death, Permanent Disability or Retirement at age 55 or older after at least three years of continuous service with the Company and its Subsidiaries (including service within a corporation or other entity acquired by the Company). “Permanent Disability” shall mean circumstances that entitled the Participant to receive benefits under the long-term disability policy maintained by the Company or any of its Subsidiaries for the participant.

(iii) Forfeiture. Unless the Compensation Committee of the Board of Directors of the Company (the “Committee”), in its sole discretion, determines otherwise, any RSUs that have not vested in accordance with this Section 3(b) shall be forfeited by the Participant upon the Participant’s termination of employment with the Company and its subsidiaries; provided, however, that a Participant’s RSUs may become vested as of the date of the Participant’s termination of employment if the termination of employment is mutually agreed to by the Participant and the Company, and the Participant (A) signs a waiver and release, in the form requested by the Company, irrevocably waiving any and all claims, liabilities and causes of action relating to the Participant’s employment with the Company and its affiliates and the termination thereof, (B) signs a noncompetition agreement in the form requested by the Company, and (C) takes any further action requested by the Company.

(c) Dividends and Distribution on Common Stock. In the event that, following the Date of Grant and prior to the settlement of any RSU, the Company pays any cash or other dividend or makes any other distribution in respect of the Common Stock, each RSU shall be credited with an additional number of RSUs (including fractions thereof) determined by dividing (i) the amount or cash, or the value (as determined by the Committee) of any other property, paid or distributed in respect of one outstanding share of Common Stock by (ii) the average of the high and low selling price of the Common Stock on the New York Stock Exchange for the date of such payment or distribution. Any RSUs so credited shall be subject to the same vesting provisions as the RSU in respect of which they are credited. Except as otherwise expressly provided in this Notice of Award, the Participant shall have no right as a shareholder with respect to any RSUs until a certificate or certificates evidencing such shares shall have been issued to the Participant according to the terms of Section 3(d) below.

(d) Delivery of Share Certificates.

(i) Ordinary Settlement. Subject to Section 3(d)(ii), settlement of any RSUs shall occur following the date on which such RSUs vest except that if the Committee elects to accelerate vesting pursuant to Section 3(b)(iii), such RSUs shall be settled after the normal vesting date as set forth in Annex A hereto. RSUs will be settled, at the election of the Participant, either by:

(A) Delivery of a stock certificate or certificates representing the number of shares of Common Stock equal to the number of RSUs being settled (any fractional RSU being rounded up to the next whole RSU). Certificates shall be issued in the name of the Participant (or of the person or persons to whom such RSUs were transferred by will or the laws of descent and distribution or pursuant to a Qualified Domestic Relations Order).

(B) The transfer of the corresponding number of shares of Common Stock equal to the number of RSUs being settled (or any fractional RSU being rounded up to the next whole RSU) to the brokerage account designated by the Participant to the Company in writing prior to settlement.

(ii) Deferred Settlement. Unless the Committee, in its sole discretion, determines otherwise, a Participant may irrevocably elect to defer settlement of any RSUs until a future date, provided that

(A) the Participant’s election is made by no later than March 15, 2005, and

(B) (i) except as otherwise provided for herein, no such settlement shall be scheduled to be made later than the July following the termination of the Participant’s employment with the Company and its subsidiaries, or (ii) if the Participant’s employment with the Company and its Subsidiaries terminates due to Retirement (defined as age 55 or older after at least three years of continuous service with the Company and its Subsidiaries), no such settlement shall be scheduled to be made later than the second anniversary of the Participant’s retirement as defined above.

A deferral election shall be made on a form provided to the Participant by the Company for this purpose.

(iii) Certain Exceptions Pursuant to Company Policy. Anything herein to the contrary notwithstanding, settlement of a RSU shall not occur on a date on which the Company’s policies then in effect prohibit the Participant from engaging in transactions in the Company’s securities. Instead, settlement shall occur on, or as promptly as practicable following, the first date that the Participant is again permitted to engage in transactions in the Company’s securities under the Company policies.

(iv) Certain Transfer Restrictions for “Covered Employees”. Subject to the other terms and conditions of this Notice of Award and the terms of the Plan, Ambac shall settle RSUs on or as soon as practicable following the later of the vesting date or the elected deferral date for settlement of RSUs; provided, however, that if the settlement date as defined in this sentence would occur at a time when the Participant is considered by Ambac to be one of its “covered employees” within the meaning of Section 162(m) of the Internal Revenue Code of 1986, as amended, or any regulations thereunder (or under any successor provisions thereto) (the “Code”), then the settlement date shall automatically be deferred until the first day of the first Window Period after the Participant has ceased to be such a covered employee. The provisions of this Section 3(d)(iv) shall not apply to the extent that the Committee determines in its sole discretion that the operation of this provision would cause this award of RSUs to cease to comply with Section 409A of the Code.

(v) Payment Restrictions for Specified Employees. If the Participant is a “Specified Employee” within the meaning of Section 409A(a)(2)(B) of the Code, then, anything in this Notice of Award to the contrary not withstanding, no settlement of RSUs in connection with the Participant’s termination of employment (other than by reason of death) shall be made before the earlier to occur of (X) the date which is six months and one day following the date of such termination of employment and (Y) the date of the Participant’s death following termination of employment.

(vi) Transfer Restrictions on Common Stock. Shares of Common Stock issued upon the settlement of RSUs will not be subject to restrictions on transfer (except for any restrictions imposed by the federal securities laws or other applicable laws or regulations and for any restrictions under the Company’s trading policies applicable to employees). However, shares of common stock issued upon settlement of RSUs granted at a discount to the Fair Market Value of Ambac stock on the date of grant will be subject to transfer restrictions until such time as the Eligible Individual meets and/or exceeds Ambac’s Stock Ownership Guidelines.

(e) Transfer Restrictions on RSUs. RSUs may not be transferred, except by will or the laws of descent and distribution or pursuant to a Qualified Domestic Relations Order.

(f) Immediate Cancellation of RSUs and Return of Share Value. Notwithstanding any other provision of this Notice of Award, the Committee may (i) cancel all or any portion of the RSUs then outstanding (whether or not then vested and whether or not subject to a deferred settlement election) and (ii) may require the Participant to repay to the Company all or any portion of the Share Value (as hereinafter defined) that the Participant realizes from the settlement of RSUs occurring within six months before or after the Participant’s termination of employment for any reason with the Company and its Subsidiaries, if the Participant engages in Competitive Activity (as defined herein) within six months following

termination of such employment. The Participant will be considered to engage in “Competitive Activity” if the Participant (1) enters into a relationship as an employee, officer, partner, member, director, independent contractor, consultant, advisor, or agent of, or in any similar relationship with, any corporation, partnership, limited liability company, joint venture or other business entity that engages in any activity which the Committee determines to be competitive with a principal business activity of the Company (a “Competitor”), where the Participant will be responsible for providing services which are similar or substantially related to the services that the Participant provided during any of the last three years of the Participant’s employment with the Company and its Subsidiaries or (2) either alone, or in concert with others, acquires or maintains beneficial ownership (within the meaning of Section 13(d) of the Securities Exchange Act of 1934, as amended) of 5% or more of any class of equity securities of a Competitor. For purposes hereof, “Share Value” in respect of an RSU means a cash amount equal to the amount of income included (or to be included) in respect of the settlement of such RSU on the Form W-2 (or successor form) that the Company or one of its Subsidiaries issues to the Participant for the year in which such settlement occurs. If the Participant is required to repay any Share Value to the Company pursuant to this Section 3(f), the Participant shall pay such amount in such manner and on such terms and conditions as the Company may require, and the Company shall be entitled to withhold or set-off against any other amount owed to the Participant by the Company or its Subsidiaries (other than any amount owed to the Participant under any retirement plan intended to be qualified under Section 401(a) of the Code) up to an amount sufficient to satisfy the unpaid obligation of the Participant under this Section 3(f).

(g) Cancellation for Specified Activity. Notwithstanding any other provision of this Notice of Award, the Committee may cancel all or any portion of the RSUs then outstanding (whether or not vested [and whether or not subject to a deferred settlement election]) if at any time the Participant initiates or becomes a party to any lawsuit or other legal action in any federal or state court in which the Participant seeks damages or injunctive or other equitable relief from or against the Company, any of its Subsidiaries or any of its officers, employees or directors in connection with any claim arising from or relating to the Participant’s employment with the Company or any of its Subsidiaries or the termination of such employment (and regardless of whether any such termination is the result of the Participant’s voluntary resignation or retirement or of the involuntary termination of the Participant’s employment by the Company or one of its subsidiaries). This Section 3(g) is not intended as a waiver by the Participant of any claims the Participant may have against the Company, any of its subsidiaries or any of its officers, employees or directors. Instead, it provides for the consequences specified in the second preceding sentence in the event the Participant engages in the conduct described therein.

4. Tax Withholding.

(a) Prior to either the transfer of shares of Common Stock to the Participant’s brokerage account or the delivery of any certificates evidencing shares of Common Stock to be issued in connection with the full or partial settlement of the RSUs, the Company shall have the right to require the Participant to remit to the Company an amount sufficient to satisfy the minimum Federal, State and local tax withholding requirements. The Company may permit the Participant to satisfy this obligation, in whole or in part, by directing the Company to withhold

shares of Common Stock that would otherwise be received by the Participant, pursuant to such rules as the Committee may establish from time to time. Under no circumstances will the Company permit the Participant to withhold shares of Common Stock in excess of the maximum Federal, state and local withholding requirements.

(b) Upon vesting of any portion of the RSUs, the Participant shall be required to satisfy, within 30 days of vesting, all Social Security and Medicare taxes due upon vesting. The Participant must submit a check or money order, payable to Ambac Financial Group, Inc., to Ambac’s Director of Human Resources or his or her designee.

5. No Restriction on Right to Effect Corporate Changes; No Right to Continued Employment.

(a) Neither the Plan, this Notice of Award, the grant of the RSUs nor any action taken hereunder shall affect in any way the right or power of the Company or its stockholders to make or authorize any or all adjustments, recapitalizations, reorganizations or other changes in the Company’s capital structure or its business, or any merger or consolidation of the Company, or any issue of bonds, debentures, preferred or prior preference stocks ahead of or convertible into, or otherwise affecting the Common Stock or the rights thereof, or the dissolution or liquidation of the Company, or any sale or transfer of all or any part of its assets or business, or any other corporate act or proceeding, whether of a similar character or otherwise.

(b) This Notice of Award is not an employment agreement. Nothing in this Notice of Award or the Plan, or the granting to the Participant of the RSUs, shall alter the Participant’s status as an ‘at-will” employee of the Company or be construed as guaranteeing employment by, or as giving the Participant any right to continue in the employ of, the Company or any of its subsidiaries during any period (including without limitation the period between the Date of Grant and the settlement date of any RSUs, or any portion thereof), or as limiting or restricting the right of the Company to terminate the Participant’s employment at any time, for any reason, with or without cause.

6. Adjustment of and Changes in Shares.

In the event of any merger, consolidation, recapitalization, reclassification, stock dividend, special cash dividend, or other change in corporate structure affecting the Common Stock, the Committee shall make such adjustments, if any, as it deems appropriate in the number and class of shares subject to the RSUs. Any adjustments shall be determined by the Committee in its sole discretion.

7. Preemption of Applicable Laws and Regulations.

Anything herein to the contrary notwithstanding, if, at any time specified herein for the issuance of shares of Common Stock to the Participant, any law, regulation or requirement of any governmental authority having jurisdiction requires either the Company or the Participant to take any action in connection with the shares then to be issued, the issuance of such shares shall be deferred until such action shall have been taken.

8. Committee Decisions Final.

Any dispute or disagreement which shall rise under, or as a result of, or pursuant to, or in connection with, this Notice of Award shall be determined by the Committee, and any such determination or any other determination by the Committee under or pursuant to this Notice of Award and any interpretation by the Committee of the terms hereof shall be final and binding on all persons affected thereby.

9. Amendments.

The Committee shall have the power to alter or amend the terms of the RSUs as set forth herein, from time to time, in any manner consistent with the Plan; provided, however, that no amendment will be made that is inconsistent with the American Jobs Creation Act of 2004. Any alteration or amendment of the terms of the RSUs by the Committee shall, upon adoption, become and be binding on all persons affected thereby without requirement for consent or other action with respect thereto by any such person. The Committee shall give written notice to the Participant of any such alteration or amendment as promptly as practicable after it is adopted. The foregoing shall not restrict the ability of the Participant and the Company by mutual consent to alter or amend the terms of the RSUs in any manner which is consistent with the Plan and approved by the Committee. Notwithstanding anything in the Plan to the contrary, the Committee may amend or terminate the Plan, without the consent of any Participant, to the extent it deems necessary or desirable to comply with the American Jobs Creation Act of 2004.

10. Notice Requirements.

Any notice which either party hereto may be required or permitted to give to the other shall be in writing. Notice may be delivered to the Company personally or by mail, postage prepaid, addressed as follows: Ambac Financial Group, Inc., One State Street Plaza, New York, New York 10004, attention: Managing Director, Human Resources, or at such other address as the Company, by notice to the Participant, may designate in writing from time to time. Notice to the Participant shall be directed either to the Participant’s address as shown on the records of the Company or at such other address as the Participant, by notice to the Company, may designate in writing from time to time or to the Participant by a combination of interoffice mail and email.

11. Governing Law.

The terms and conditions stated herein are to be governed by, and construed in accordance with, the laws of the State of Delaware.

12. Entire Agreement; Headings.

This Notice of Award (which includes Annex A) and the other related documents expressly referred to herein set forth the entire agreement and understanding between the parties hereto and supersede all prior agreements and understandings relating to the subject matter hereof. The headings of Sections and subsections herein are included solely for convenience of reference and shall not affect the meaning of any of the provisions of this Notice of Award.

EX-10.08

EXHIBIT 10.08

Ambac 1997 Equity Plan

FORM OF STOCK OPTION AWARD AGREEMENT

Table of Contents

1.	Incorporation of Plan Terms	1
2.	Grant of Option	1
3.	Terms and Conditions of the Option	1
4.	Termination of Employment	3
5.	Transfer; Option Exercisable Only by Participant and Permitted Transferees	5
6.	Tax Withholding	5
7.	No Restriction on Right to Effect Corporate Changes; No Right to Employment	5
8.	Adjustment of and Changes in Shares	6
9.	Change in Control	6
10.	Preemption of Applicable Laws and Regulations	7
11.	Committee Decisions Final	7
12.	Amendments	7
13.	Notice Requirements	8
14.	Governing Law	8
15.	Entire Agreement; Headings	8

Annex A: Stock Option Award and Vesting Schedule

Ambac 1997 Equity Plan

FORM OF STOCK OPTION AWARD AGREEMENT

Ambac Financial Group, Inc., a Delaware corporation (the “Company”), has adopted the Ambac 1997 Equity Plan, as amended (the “Plan”), for the purposes of providing an incentive to selected employees of the Company and its affiliates to remain in its employ and to increase their interest in the success of the Company by providing them with opportunities to increase their proprietary interest in the Company and to receive compensation based upon the Company’s success.

This 2005 Stock Option Award Agreement (the “Award Agreement”) sets forth the terms and conditions of the stock options granted pursuant to the Plan. Annex A of this Award Agreement (“Annex A”) names the individual to whom the option is granted (the “Participant”) and sets forth the number of shares of common stock of the Company (“Common Stock”) subject to the option, the exercise price of such option, the date of grant and the expiration date of such option and the vesting schedule applicable thereto.

1. Incorporation of Plan Terms.

This Award Agreement and the option granted hereby shall be subject to the Plan, the terms of which are incorporated herein by reference, and in the event of any conflict or inconsistency between the Plan and this Award Agreement, the Plan shall govern. Capitalized terms used herein without definition shall have the meanings assigned to them in the Plan, a copy of which has been furnished to the Participant.

2. Grant of Option.

Subject to the conditions contained herein and in the Plan, the Company grants to the Participant, as of the date of grant indicated on Annex A (the “Date of Grant”), an option (the “Option”) to purchase the number of shares of Common Stock specified on Annex A, at an exercise price (the “Exercise Price”) specified on Annex A. The shares of Common Stock issuable upon exercise of the Option are from time to time referred to herein as the “Option Shares.” The grant of an Option shall impose no obligation on the part of the Participant to exercise the Option. The Option shall vest and be exercisable as hereinafter provided.

3. Terms and Conditions of the Option.

The Option is granted subject to the following terms and conditions:

(a) Vesting; Exercisability. The Option shall vest and become exercisable in accordance with the vesting schedule set forth on Annex A, unless the Option has earlier vested or been forfeited in accordance with the terms hereof.

(b) Term of the Option. The Option shall terminate and no longer be exercisable on the earlier of (i) the seventh anniversary of the Date of Grant or (ii) the date specified for termination of the Option in Sections 4(a), 4(b) and 4(c) below; provided, however, if the termination date falls on a date which the Participant is prohibited by Corporation policy in effect on such date, from engaging in transactions in the Corporation’s securities, such termination date shall be extended to ten business days following the first date that the Participant is permitted to engage in transactions in the Corporation’s securities under such Corporation policy.

(c) Notice of Exercise. Subject to Sections 3(d), 3(f) and 4 hereof, the Participant may exercise all or any portion of the Option (to the extent vested) by giving notice of exercise to the Company or the Company’s agent, provided, however, that no less than 10 Option Shares may be purchased upon any exercise of the Option unless the

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number of Option Shares purchased at such time is the total number of Option Shares in respect of which the Option is then exercisable, and provided, further, that in no event shall the Option be exercisable for a fractional share. The date of exercise of an Option shall be the later of (i) the date on which the Company or the Company’s agent receives such notice or (ii) the date on which the conditions provided in Sections 3(d) and 3(f) are satisfied. Notwithstanding any other provision of this Award Agreement, the Participant may not exercise the Option, whether in whole or in part, and no Option Shares will be issued by the Company in respect of any such attempted exercise, at any time when such exercise is prohibited by Company policy then in effect concerning transactions by the Participant in the Company’s securities.

(d) Payment. Prior to the issuance of a certificate pursuant to Section 3(g) hereof evidencing the Option Shares in respect of which all or a portion of the Option shall have been exercised, the Participant shall have paid to the Company the Exercise Price for all Option Shares purchased pursuant to the exercise of such Option. Payment may be made by personal check, bank draft or postal or express money order (such modes of payment are collectively referred to as “cash”) payable to the order of the Company in U.S. dollars. Payment may also be made in mature shares of Common Stock owned by the Participant, or in any combination of cash or such mature shares as the Committee in its sole discretion may approve. Such shares shall be valued at their Fair Market Value as of the date of exercise. Payment of the Exercise Price in mature shares of Common Stock owned by the Participant shall be made by delivering to the Company the share certificate(s) representing the required number of shares, with the Participant signing his or her name on the back, or by attaching executed stock powers (with the signature of the Participant guaranteed in either case); payment of the exercise price in mature shares of Common Stock owned by the Participant may also be made through constructive surrender, by submission of an attestation of ownership in the form approved by the Company and with such signatures or other guarantees as may be required by the Company. The Company may also permit the Participant to pay for such Option Shares by directing the Company to withhold shares of Common Stock that would otherwise be received by the Participant, pursuant to such rules as the Committee may establish from time to time. In the discretion of the Committee, and in accordance with rules and procedures established by the Committee (or by any person to whom authority to establish such rules and procedures shall have been delegated by the Committee), the Participant may be permitted to make a “cashless” exercise of all or a portion of the Option.

(e) Stockholder Rights. The Participant shall have no rights as a stockholder with respect to any shares of Common Stock issuable upon exercise of the Option until the Participant shall become the holder of record thereof, and no adjustment shall be made for dividends or distributions or other rights in respect of any share for which the record date is prior to the date upon which the Participant shall become the holder of record thereof.

(f) Limitation on Exercise. The Option shall not be exercisable unless the offer and sale of Common Stock pursuant thereto has been registered under the Securities Act of 1933, as amended (the “1933 Act”), and qualified under applicable state “blue sky” laws or the Company has determined that an exemption from registration under the 1933 Act and from qualification under such state “blue sky” laws is available.

(g) Issuance of Shares. Subject to the foregoing conditions, as soon as is reasonably practicable after its receipt of a proper notice of exercise and payment of the Exercise Price for the number of shares with respect to which the Option is exercised, the Company either (i) shall deliver or cause to be delivered to the Participant (or to such person to whom the Option has been transferred pursuant to Section 5 hereof; or following the Participant’s death, to such other person entitled to exercise the Option), at the principal office of the Company or at such other location as may be acceptable to the Company and the Participant (or such other person), one or more stock certificates in the name of the Participant (or of the person or persons to whom such option was transferred by will or the laws of descent and distribution or pursuant to a Qualified Domestic Relations Order) for the appropriate number of shares of Common Stock issued in connection with such exercise or (ii) shall transfer the appropriate number of shares of Common Stock issued in connection with such exercise to the brokerage account designated by the Participant to the Company in writing prior to exercise. Such shares shall be fully paid and nonassessable.

(h) Non-qualified Status of the Option. The Option granted hereby is not intended to qualify, and shall not be treated, as an “incentive stock option” within the meaning of Section 422 of the Internal Revenue Code of 1986, as amended (the “Code”).

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(i) Cancellation. Notwithstanding any other provision of this Award Agreement, the Committee may cancel all or any unexercised portion of the Option, whether or not vested, if at any time the Participant initiates or becomes a party to any lawsuit or other legal action in any federal or state court in which the Participant seeks damages or injunctive or other equitable relief from or against the Company, any of its Subsidiaries or any of its officers, employees or directors in connection with any claim arising from or relating to the Participant’s employment with the Company or any of its Subsidiaries or the termination of such employment (and regardless of whether any such termination is the result of the Participant’s voluntary resignation or retirement or of the involuntary termination of the Participant’s employment by the Company or one of its subsidiaries). This Section 3(i) is not intended as a waiver by the Participant of any claims the Participant may have against the Company, any of its subsidiaries or any of its officers, employees or directors. Instead, it provides for the consequences specified in the second preceding sentence in the event the Participant engages in the conduct described therein.

4. Termination of Employment.

(a) General. Subject to Section 4(c) hereof, if the Participant’s employment with the Company and its Subsidiaries terminates for any reason other than death or Permanent Disability (as defined herein) prior to the satisfaction of any vesting period requirement under Section 3(a) hereof, the unvested portion of the Option shall be forfeited to the Company, and the Participant shall have no further right or interest therein, unless the Committee in its sole discretion shall determine otherwise, provided, however, that in the case of a termination of employment mutually agreed to by the Participant and the Company (or the relevant employer Subsidiary), but not in the case of a termination for Cause (as defined herein), if the Participant (A) signs a waiver and a release, in the form requested by the Company, irrevocably waiving any and all claims and liabilities relating to the Participant’s employment with the Company and its affiliates and the termination thereof, (B) signs a noncompetition agreement in the form requested by the Company, and (C) takes any further action requested by the Company to perfect such release and waiver, then at the Company’s discretion, the Option shall be deemed to have vested in full as of the date of the Participant’s termination of employment.

(b) Exercise Following Termination of Employment. If the Participant’s employment with the Company and its Subsidiaries terminates for any reason other than death, Permanent Disability or Retirement (as defined herein) after the Option has vested in accordance with Sections 3(a) and 4(a) hereof with respect to all or a portion of the shares of Common Stock subject to the Option, the Participant shall have the right, subject to the terms and conditions hereof and of the Plan, to exercise the Option, to the extent it has vested as of the date of such termination of employment, at any time within one year after the date of such termination, subject to the earlier expiration of the Option as provided in Section 3(b).

(c) Exercise Following Termination of Employment Due to Death, Permanent Disability or Retirement.

(i) If the Participant’s employment with the Company and its Subsidiaries terminates due to (A) death or (B) Permanent Disability or (C) Retirement at age 55 or older after at least three years of continuous service with the Company and its Subsidiaries (including service with a corporation or other entity acquired by the Company), in any such case prior to the satisfaction of any vesting period requirement under Section 3(a) hereof, the Option shall be deemed to have vested in full as of the date of death, termination due to Permanent Disability or such Retirement.

(ii) Following termination of employment due to death or Permanent Disability, the Option may be exercised by the Participant, or the Participant’s Permitted Transferee, estate, personal representative or beneficiary, as the case may be, within three years after the date of death or termination of employment due to Permanent Disability, subject to the earlier expiration of the Option as provided in Section 3(b). In the event of Retirement (whether or not Retirement results in full vesting of the Option pursuant to clause (i) above), the Participant or the Participant’s Permitted Transferee may exercise the Option, to the extent it has vested as of the date of Retirement, within three years after the date of Retirement, subject to the earlier expiration of the Option as provided in Section 3(b).

(d) Definitions. For purposes hereof, the following terms shall have the meanings specified below:

(i) Termination of Employment. The employment of the Participant shall be deemed terminated if the Participant is no longer employed by the Company or any of its Subsidiaries for any reason. The Committee shall have

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discretion to determine whether military or government service or an authorized leave of absence (as a result of disability or otherwise) shall constitute a termination of employment for purposes hereof.

(ii) Cause. Each of the following shall constitute “Cause” for termination of employment:

(a) the willful commission by the Participant of acts that are dishonest and demonstrably and materially injurious to the Company or any of its Subsidiaries or affiliates, monetarily or otherwise;

(b) the conviction of the Participant for a felonious act resulting in material harm to the financial condition or business reputation of the Company or any of its Subsidiaries or affiliates; or

(c) except for actions taken in the course of the Participant’s employment or as required by law, the Participant’s divulgation, furnishing or making accessible to any person any information of a confidential or proprietary nature obtained while in the employ of the Company or any of its Subsidiaries of affiliates, or the Participant’s failure, upon termination of his employment with the Company or any of its Subsidiaries or affiliates, to return to the Company all such information which exists in written or any other form (including without limitation in the form of computer files or disks) and all copies thereof in his possession or under his control.

Notwithstanding the foregoing, if the Company or any of its Subsidiaries or affiliates has entered or enters into any employment, management retention, change in control, severance or similar agreement with the Participant, which agreement sets forth a definition of “Cause”, then such definition, rather than the definition set forth above, shall control for purposes of this Award Agreement.

(iii) Permanent Disability. “Permanent Disability” shall mean circumstances that entitle the Participant to receive benefits under the long-term disability policy maintained by the Company or any of its Subsidiaries for the Participant.

(iv) Retirement. “Retirement” shall mean the termination of the Participant’s employment on or after age 55, except for Cause.

(e) Exercise Following Termination of Employment Subject to Company Policies on Insider Trading. Any exercise of the Option pursuant to Section 4(b) or 4(c) above following termination of the Participant’s employment for any reason other than death shall be subject to, and shall be permitted only to the extent such exercise complies with, the policies of the Company concerning insider trading.

(f) Cancellation of Option and Repayment of Option Gain. Notwithstanding any other provision of this Award Agreement, the Committee may cancel all or any portion of the Option, whether or not vested, and may require the Participant to repay to the Company all or any portion of the Option Gain (as defined herein) that the Participant realizes from any full or partial exercise of the Option occurring within six months before or after the termination of the Participant’s employment with the Company and its Subsidiaries, if the Participant engages in Competitive Activity (as defined herein) within six months following the termination of the Participant’s employment. A Participant will be considered to engage in “Competitive Activity” if the Participant (1) enters into a relationship as an employee, officer, partner, member, director, independent contractor, consultant, advisor or agent of, or in any similar relationship with, any corporation, partnership, limited liability company, joint venture or other business entity that engages in any activity which the Committee determines is competitive with a principal business activity of the Company (a “Competitor”), where the Participant will be responsible for providing services which are similar or substantially related to the services that the Participant provided during any of the last three years of the Participant’s employment with the Company and its Subsidiaries or (2) either alone, or in concert with others, acquires or maintains beneficial ownership (within the meaning of Section 13(d) of the Exchange Act) of 5% or more of any class of equity securities of a Competitor. The amount of a Participant’s “Option Gain” realized upon full or partial exercise of an Option is the amount of income included (or to be included) in respect of such exercise on the Form W-2 (or successor form) that the Company or one

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of its Subsidiaries issues to the Participant for the year in which such exercise occurs. The Company may require the Participant, in connection with any full or partial exercise of an Option, to certify in a manner acceptable to the Company that the Participant has not engaged in Competitive Activity and may decline to give effect to such exercise if the Participant fails so to certify. If the Participant is required to repay any Option Gain to the Company pursuant to this Section 4(f), the Participant shall pay such amount in such manner and on such terms and conditions as the Company may require, and the Company shall be entitled to withhold or set-off against any other amount owed to the Participant by the Company or any of its Subsidiaries (other than any amount owed to the Participant under any retirement plan intended to be qualified under Section 401(a) of the Code) up to any amount sufficient to satisfy any unpaid obligation of the Participant under this Section 4(f).

5. Transfer; Option Exercisable Only by Participant and Permitted Transferees.

The Option may not be transferred, pledged, assigned, or otherwise disposed of, except (i) by will or the laws of descent and distribution, (ii) pursuant to a domestic relations order or (iii) for no consideration, to a member or members of the Participant’s immediate family (as defined below) or to one or more trusts or partnerships established in whole or in part for the benefit of one or more of such immediate family members (the parties identified in clauses (i), (ii), and (iii) being referred to collectively as “Permitted Transferees”). If the Option is transferred to a Permitted Transferee, it shall be further transferable only by will or the laws of descent and distribution or, for no consideration, to another Permitted Transferee of the Participant. The Participant shall promptly notify the Company of any proposed transfer to a Permitted Transferee in advance in writing and shall upon request provide the Company with information concerning the Permitted Transferee’s financial condition and investment experience. No assignment or transfer of the Option, or of the rights represented thereby, whether voluntary or involuntary, by operation of law or otherwise, except as permitted by this Section 5, shall vest in the assignee or transferee any interest or right in the Option, but immediately upon any attempt to assign or transfer the Option the same shall terminate and be of no force or effect. For purposes of this Option Agreement, the Participant’s “immediate family” means any child, stepchild, grandchild, spouse, son-in-law or daughter-in-law and shall include adoptive relationships.

6. Tax Withholding.

The Company shall have the right, prior to the issuance of shares as set forth in section 3(g) hereor, to require the Participant to remit to the Company any amount sufficient to satisfy the minimum required Federal, state or local tax withholding requirements. The Company may permit the Participant to satisfy, in whole or in part, such obligation to remit taxes, by directing the Company to withhold shares of Common Stock that would otherwise be received by the Participant, pursuant to such rules as the Committee may establish from time to time. The Company shall also have the right to deduct from all cash payments made pursuant to or in connection with the Option the minimum required Federal, state or local taxes required to be withheld with respect to such payments or, if the Participant so elects, up to the maximum Federal, state or local income taxes or such lesser amount as determined by the Company in order to assure that it complies with applicable accounting standards.

7. No Restriction on Right to Effect Corporate Changes; No Right to Employment.

Neither the Plan, this Award Agreement nor the existence of the Option shall affect in any way the right or power of the Company or its stockholders to make or authorize any or all adjustments, recapitalizations, reorganizations or other changes in the Company’s capital structure or its business, or any merger or consolidation of the Company, or any issue of bonds, debentures, preferred or prior preference stocks ahead of or convertible into, or otherwise affecting the Common Stock or the rights thereof, or the dissolution or liquidation of the Company, or any sale or transfer of all or any part of its assets or business, or any other corporate act or proceeding, whether of a similar character or otherwise.

In addition, neither this Award Agreement, the grant of the Option nor any action taken hereunder shall be deemed to limit or restrict the right of the Company to terminate the Participant’s employment at any time, for any reason, with or without Cause.

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8. Adjustment of and Changes in Shares.

In the event of any merger, consolidation, recapitalization, reclassification, stock dividend, special cash dividend, or other change in corporate structure affecting the Common Stock, the Committee shall make such adjustments, if any, as it deems appropriate in the number and class of shares subject to, and the exercise price of, the Option. The foregoing adjustments shall be determined by the Committee in its sole discretion.

9. Change in Control.

(a) Committee Discretion to Take Certain Actions. The Committee, in its sole discretion, may at any time prior to, coincident with or after the time of a Change in Control (as defined herein):

(i) provide for the acceleration of any vesting conditions relating to the exercise of the Option or that the Option may be exercised in full on or before a date fixed by the Committee;

(ii) provide for the purchase of the Option, upon the Participant’s request, for an amount of cash equal to the amount, as determined by the Committee in its sole discretion, which could have been realized upon the exercise of the Option had the Option been currently exercisable;

(iii) make such adjustments to the Option as the Committee deems appropriate to reflect such Change in Control; or

(iv) cause the Option then to be assumed, or new rights substituted therefor, by the surviving corporation in such Change in Control.

Any such actions shall be authorized by the Committee, whose determination as to what actions shall be taken and the extent thereof, shall be final.

(b) Definitions. For purposes hereof, a “Change in Control” shall be deemed to occur on the date on which one of the following events occurs:

(i) the acquisition by any Person of beneficial ownership (within the meaning of Rule 13d-3 promulgated under the Exchange Act) of 20% or more of the Common Stock then outstanding, but shall not include any such acquisition by:

(A) the Company;

(B) any Subsidiary of the Company;

(C) any employee benefit plan of the Company or of any Subsidiary of the Company;

(D) any Person or entity organized, appointed or established by the Company for or pursuant to the terms of any such plan;

(E) any Person who as of January 31, 1996 was the beneficial owner of 15% or more of the shares of Common stock outstanding on such date unless and until such Person, together with all affiliates and associates of such Person, becomes the beneficial owner of 25% or more of the shares of Common stock then outstanding whereupon a Change in Control shall be deemed to have occurred; or

(F) any Person who becomes the beneficial owner of 20% or more, or, with respect to a Person described in clause (E) above, 25% or more, of the shares of Common Stock then outstanding as a result of a reduction in the number of shares of Common Stock outstanding due to the repurchase of shares of Common Stock by the Company unless and until such Person, after becoming aware that such Person has become the beneficial owner of 20% or more, or 25% or more, as the case may be, of the then outstanding shares of Common Stock, acquires beneficial ownership of additional shares of Common

6

Stock representing 1% or more of the shares of Common Stock then outstanding, whereupon a Change in Control shall be deemed to have occurred; or

(ii) individuals who, as of July 30, 1997, constitute the Board, and subsequently elected members of the Board whose election is approved or recommended by at least a majority of such current members or their successors whose election was so approved or recommended (other than any subsequently elected members whose initial assumption of office occurs as a result of an actual or threatened election contest with respect to the election or removal of directors or other actual or threatened solicitation of proxies or consents by or on behalf of a person other than the Board), cease for any reason to constitute at least a majority of such Board; or

(iii) approval by the stockholders of the Company of (A) a merger or consolidation of the Company with any other corporation, (B) the issuance of voting securities of the Company in connection with a merger or consolidation of the Company (or any Subsidiary) pursuant to applicable stock exchange requirements, or (C) sale or disposition of all or substantially all of the assets of the Company or the acquisition of assets of another corporation (each, a “Business Combination”), unless, in each case, immediately following such Business Combination, all or substantially all of the individuals and entities who were the beneficial owners of the Common Stock outstanding immediately prior to such Business Combination beneficially own, directly or indirectly, more than 70% of the then outstanding shares of Common Stock and 70% of the combined voting power of the then outstanding voting securities entitled to vote generally in the election of directors, as the case may be, of the corporation resulting from such Business Combination (including, without limitation, a corporation which as a result of such transaction owns the Company or all or substantially all of the Company’s assets either directly or through one or more subsidiaries) in substantially the same proportions as their ownership, immediately prior to such Business Combination, of the Common Stock.

As used herein, “Person” means any individual, firm, corporation, partnership or other entity.

10. Preemption of Applicable Laws and Regulations.

Anything herein to the contrary notwithstanding, if, at any time specified herein for the issuance of shares of Common Stock to the Participant, any law, regulation or requirement of any governmental authority having jurisdiction shall require either the Company or the Participant to take any action in connection with the shares then to be issued, the issuance of such shares shall be deferred until such action shall have been taken.

11. Committee Decisions Final.

Any dispute or disagreement which shall arise under, or as a result of, or pursuant to, or in connection with, this Award Agreement or the Option shall be determined by the Committee, and any such determination or any other determination by the Committee under or pursuant to this Award Agreement and any interpretation by the Committee of the terms of the Option shall be final and binding on all persons affected thereby.

12. Amendments.

The Committee shall have the power to alter or amend the terms of the Option as set forth herein from time to time, in any manner consistent with the provisions of Section 16 of the Plan, and any alteration or amendment of the terms of the Option by the Committee shall, upon adoption, become and be binding on all persons affected thereby without requirement for consent or other action with respect thereto by any such person. The Committee shall give written notice to the Participant of any such alteration or amendment as promptly as practicable after the adoption thereof. The foregoing shall not restrict the ability of the Participant and the Company by mutual consent to alter or amend the terms of the Option in any manner which is consistent with the Plan and approved by the Committee. In addition, the terms of the Option may be amended or supplemented by any employment, management retention, severance or similar agreement (an “Employment Agreement”) entered into between the Company and the Participant (including any such agreement entered into prior to the Date of Grant) and approved, to the extent such Employment Agreement amends or supplements the terms of the Option, by the Committee.

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13. Notice Requirements.

Any notice which either party hereto may be required or permitted to give to the other shall be in writing. Such notice may be delivered to the Company personally or by mail, postage prepaid, addressed as follows: Ambac Financial Group, Inc., One State Street Plaza, New York, New York 10004, attention: Managing Director, Human Resources, or at such other address as the Company, by notice to the Participant, may designate in writing from time to time, and to the Participant at the Participant’s address as shown on the records of the Company or at such other address as the Participant, by notice to the Company, may designate in writing from time to time.

14. Governing Law.

The terms and conditions stated herein are to be governed by, and construed in accordance with, the laws of the State of Delaware.

15. Entire Agreement; Headings.

This Award Agreement (which includes Annex A) and the other related documents expressly referred to herein (including, if applicable, any Employment Agreement) set forth the entire agreement and understanding between the parties hereto and supersede all prior agreements and understandings relating to the subject matter hereof. In the event of a discrepancy or inconsistency in the number of shares of common stock covered by the Option, the Date of Grant, the vesting schedule, the Exercise Price or any other term in this Award Agreement and the resolutions of the Committee authorizing the grant of the Option covered hereby, such resolutions shall control and the Company shall have the right, in its sole discretion, to replace the Award Agreement or any portion thereof (including any portion of Annex A) with a correct version. The headings of Sections and subsections herein are included solely for convenience of reference and shall not affect the meaning of any of the provisions of this Award Agreement.

AMBAC FINANCIAL GROUP, INC.

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EX-10.09

EXHIBIT 10.09

AMBAC FINANCIAL GROUP, INC.

1997 EQUITY PLAN

JANUARY 2004 NOTICE OF AWARD OF RESTRICTED STOCK UNITS

Ambac Financial Group, Inc., a Delaware corporation and its Subsidiaries (referred to herein as either the “Company” or “Ambac”), have adopted the Ambac 1997 Equity Plan (the “Plan”), for the purposes of providing an incentive to selected employees of the Company and its affiliates to remain in its employ and to increase their interest in the success of the Company. The Company pursues these goals by providing selected employees with opportunities through the Plan to increase their proprietary interest in the Company and to receive compensation based upon the Company’s success.

This 2004 Restricted Stock Unit notice of award (the “Notice of Award”) sets forth the terms and conditions of the restricted stock units that have been granted under the Plan to the individual identified on Annex A (the “Participant”). This Notice of Award sets forth the number of restricted stock units that the Participant will receive, the date of grant and the applicable vesting schedule.

1. Incorporation of Plan Terms.

This Notice of Award and the restricted stock units granted hereby are subject to the Plan, the terms of which are incorporated herein by reference. If there is any conflict or inconsistency between the Plan and this Notice of Award, the Plan shall govern. Capitalized terms used in this Notice of Award without definition shall have the meanings assigned to them in the Plan. A copy of the Plan is available on Ambac’s intranet site.

2. Grant of Restricted Stock Units.

Subject to the conditions contained herein and in the Plan, the Company grants to the Participant, as of the date of grant indicated on Annex A (the “Date of Grant”), the number of restricted stock units (the “RSUs”) specified on Annex A.

3. Terms and Conditions of the RSUs.

The RSUs shall have the following terms and conditions:

(a) General. Each RSU shall represent the unsecured promise of the Company to transfer to the Participant, on the settlement date of such RSU and subject to the terms and conditions set forth in this Notice of Award, one share of the Company’s common stock, par value $0.01 per share (the “Common Stock”).

(b) Vesting.

(i) Normal Vesting. The RSUs, including any additional RSUs credited to the Participant’s Account, shall vest on the third anniversary of the Date of Grant.

(ii) Accelerated Vesting. Notwithstanding Section 3(b)(i), all of the Participant’s RSUs shall immediately vest upon the first to occur of (A) the Participant’s ceasing to be a member of the Board as a result of retirement or resignation from the Board, or (B) the Participant’s ceasing to be a member of the Board as a result of death or Permanent Disability (as defined below).

(iii) Forfeiture. Unless the Compensation Committee of the Board of Directors of the Company (the “Committee”), in its sole discretion, determines otherwise, any RSUs that have not vested in accordance with this Section 3(b) shall be forfeited by the Participant if the Participant is of removed as Chairman of the Board or as a member of the Board for “Cause”. “Cause” shall be defined as (i) the willful commission by the Participant of acts that are dishonest and demonstrably and materially injurious to the Company or any of its Affiliates, monetarily or otherwise or (ii) the conviction of the Participant, or his pleading guilty or “ nolo contendre” for a felony resulting in material harm to the financial condition or business reputation of the Company or any of its Affiliates.

(c) Dividends and Distribution on Common Stock. In the event that, following the Date of Grant and prior to the settlement of any RSU, the Company pays any cash or other dividend or makes any other distribution in respect of the Common Stock, each RSU shall be credited with an additional number of RSUs (including fractions thereof) determined by dividing (i) the amount or cash, or the value (as determined by the Committee) of any other property, paid or distributed in respect of one outstanding share of Common Stock by (ii) the average of the high and low selling price of the Common Stock on the New York Stock Exchange for the date of such payment or distribution. Any RSUs so credited shall be subject to the same vesting provisions as the RSU in respect of which they are credited. Except as otherwise expressly provided in this Notice of Award, the Participant shall have no right as a shareholder with respect to any RSUs until a certificate or certificates evidencing such shares shall have been issued to the Participant according to the terms of Section 3(d) below.

(d) Delivery of Share Certificates.

(i) Ordinary Settlement. Subject to Section 3(d)(ii), settlement of any RSUs shall occur promptly following the date on which such RSUs vest. RSUs will be settled, at the election of the Participant, either by:

(A) Delivery of a stock certificate or certificates representing the number of shares of Common Stock equal to the number of RSUs being settled (any fractional RSU being rounded up to the next whole RSU). Certificates shall be issued in the name of the Participant (or of the person or persons to whom such RSUs were transferred by will or the laws of descent and distribution or pursuant to a Qualified Domestic Relations Order).

(B) The transfer of the corresponding number of shares of Common Stock equal to the number of RSUs being settled (or any fractional RSU being rounded up to the next whole RSU) to the brokerage account designated by the Participant to the Company in writing prior to settlement.

(ii) Deferred Settlement. Unless the Committee, in its sole discretion, determines otherwise, a Participant may irrevocably elect to defer settlement of any RSUs until a future date, provided that

(A) (i) the Participant’s election is made no later than six months preceding the first year in which all or any portion of the RSUs are scheduled to vest

AND

(B) no such settlement may extend beyond the earlier of (i) the termination of the Participant’s service on the Board or (ii) the Participant’s death.

A deferral election shall be made on a form provided to the Participant by the Company for this purpose.

(iii) Certain Exceptions Pursuant to Company Policy. Anything herein to the contrary notwithstanding, settlement of a RSU shall not occur on a date on which the Company’s policies then in effect prohibit the Participant from engaging in transactions in the Company’s securities. Instead, settlement shall occur on, or as promptly as practicable following, the first date that the Participant is again permitted to engage in transactions in the Company’s securities under the Company policies.

(iv) Transfer Restrictions on Common Stock. Shares of Common Stock issued upon the settlement of RSUs will not be subject to restrictions on transfer (except for

any restrictions imposed by the federal securities laws or other applicable laws or regulations and for any restrictions under the Company’s trading policies applicable to employees

(e) Transfer Restrictions on RSUs. RSUs may not be transferred, except by will or the laws of descent and distribution or pursuant to a Qualified Domestic Relations Order.

4. Tax Withholding.

The Company shall not, unless required or permitted by the Internal Revenue Code or applicable accounting rules or regulations, withhold shares of Common Stock that would otherwise be received by the Participant or deduct from cash payments to be made pursuant to or in connection with the settlement of the RSUs, any amount for the purpose of satisfying any Federal, state or local tax withholding requirement.

The Company, to the extent required or permitted by the Internal Revenue Code and/or applicable accounting rules, shall have the right, prior to the delivery of any certificates evidencing shares of Common Stock to be issued upon full or partial settlement of the RSUs, to require the Participant to remit to the Company any amount sufficient to satisfy any Federal, state or local tax withholding requirements. The Company may permit the Participant to satisfy, in whole or in part, such obligation to remit taxes, by directing the Company to withhold shares of Common Stock that would otherwise be received by the Participant, pursuant to such rules as the Board may establish from time to time. The Company shall also have the right to deduct from all cash payments made pursuant to or in connection with the RSUs any Federal, state or local taxes required to be withheld with respect to such payments.

5. No Restriction on Right to Effect Corporate Changes.

Neither the Plan, this Notice of Award, the grant of the RSUs nor any action taken hereunder shall affect in any way the right or power of the Company or its stockholders to make or authorize any or all adjustments, recapitalizations, reorganizations or other changes in the Company’s capital structure or its business, or any merger or consolidation of the Company, or any issue of bonds, debentures, preferred or prior preference stocks ahead of or convertible into, or otherwise affecting the Common Stock or the rights thereof, or the dissolution or liquidation of the Company, or any sale or transfer of all or any part of its assets or business, or any other corporate act or proceeding, whether of a similar character or otherwise.

In addition, neither the Plan, this Notice of Award, the grant of the RSUs nor any action taken hereunder shall be deemed to create any obligation on the part of the Board to nominate the Participant for re-election by the Company’s stockholders, nor confer upon the Participant the right to remain a member of the Board for any period of time or at any particular rate of compensation.

6. Adjustment of and Changes in Shares.

In the event of any merger, consolidation, recapitalization, reclassification, stock dividend, special cash dividend, or other change in corporate structure affecting the Common Stock, the Committee shall make such adjustments, if any, as it deems appropriate in the number and class of shares subject to the RSUs. Any adjustments shall be determined by the Committee in its sole discretion.

7. Preemption of Applicable Laws and Regulations.

Anything herein to the contrary notwithstanding, if, at any time specified herein for the issuance of shares of Common Stock to the Participant, any law, regulation or requirement of any governmental authority having jurisdiction requires either the Company or the Participant to take any action in connection with the shares then to be issued, the issuance of such shares shall be deferred until such action shall have been taken.

8. Committee Decisions Final.

Any dispute or disagreement which shall rise under, or as a result of, or pursuant to, or in connection with, this Notice of Award shall be determined by the Committee, and any such determination or any other determination by the Committee under or pursuant to this Notice of Award and any interpretation by the Committee of the terms hereof shall be final and binding on all persons affected thereby.

9. Amendments.

The Committee shall have the power to alter or amend the terms of the RSUs as set forth herein, from time to time, in any manner consistent with the Plan. Any alteration or amendment of the terms of the RSUs by the Committee shall, upon adoption, become and be binding on all persons affected thereby without requirement for consent or other action with respect thereto by any such person. The Committee shall give written notice to the Participant of any such alteration or amendment as promptly as practicable after it is adopted. The foregoing shall not restrict the ability of the Participant and the Company by mutual consent to alter or amend the terms of the RSUs in any manner which is consistent with the Plan and approved by the Committee.

10. Notice Requirements.

Any notice which either party hereto may be required or permitted to give to the other shall be in writing. Notice may be delivered to the Company personally or by mail, postage prepaid, addressed as follows: Ambac Financial Group, Inc., One State Street Plaza, New York, New York 10004, attention: Managing Director, Human Resources, or at such other address as

the Company, by notice to the Participant, may designate in writing from time to time. Notice to the Participant shall be directed either to the Participant’s address as shown on the records of the Company or at such other address as the Participant, by notice to the Company, may designate in writing from time to time or to the Participant by a combination of interoffice mail and email.

11. Governing Law.

The terms and conditions stated herein are to be governed by, and construed in accordance with, the laws of the State of Delaware.

12. Entire Agreement; Headings.

This Notice of Award (which includes Annex A) and the other related documents expressly referred to herein set forth the entire agreement and understanding between the parties hereto and supersede all prior agreements and understandings relating to the subject matter hereof. The headings of Sections and subsections herein are included solely for convenience of reference and shall not affect the meaning of any of the provisions of this Notice of Award.

Annex A

2004 RESTRICTED STOCK UNITS AWARD

Participant:    Phillip B. Lassiter	Social Security No: ____________
Number of RSUs
Granted:          50,000	Date of Grant:   January 26, 2004
Vesting Date:   January 26, 2007

AMBAC FINANCIAL GROUP, INC.
By:
	Gregg L. Bienstock
	Managing Director,
	Human Resources and Employment Counsel

EX-10.11

EXHIBIT 10.11

AMBAC FINANCIAL GROUP, INC.

1997 NON-EMPLOYEE DIRECTORS EQUITY PLAN

(as amended through May 4, 2004)

1. Purpose

The purpose of the Ambac Financial Group, Inc. 1997 Non-Employee Directors Equity Plan (the “Plan”) is to promote the long-term growth and financial success of the Company by attracting, motivating and retaining non-employee directors of outstanding ability and assisting the Company in promoting a greater identity of interest between the Company’s non-employee directors and its stockholders.

The Plan replaces the AMBAC Inc. 1991 Non-Employee Directors Stock Plan (the “Predecessor Plan”). From and after the effective date of the Plan as provided in Section 11 below, no further awards shall be made under the Predecessor Plan.

2. Definitions

For purposes of the Plan, the following terms shall be defined as follows:

“Annual Award” means an Award of Director Options (made in respect of Annual Meetings up to and including the 2003 Annual Meeting) or Director Annual Stock Units (made in respect of Annual Meetings beginning with the 2004 Annual Meeting), in each case as provided in Section 7 below.

“Annual Meeting” means an annual meeting of the Company’s stockholders.

“Award” means any or all (as the context requires) of Director Annual Stock Units, Director Five-Year Stock Units and Director Options.

“Board” means the Board of Directors of the Company.

“Change in Control” means:

(i) the acquisition by any Person of beneficial ownership (within the meaning of Rule 13d-3 promulgated under the Exchange Act) of 20% or more of the Common Stock then outstanding, but shall not include any such acquisition by:

(A) the Company;

(B) any Subsidiary of the Company;

(C) any employee benefit plan of the Company or of any Subsidiary of the Company;

(D) any Person or entity organized, appointed or established by the Company for or pursuant to the terms of any such plan;

(E) any Person who as of January 31, 1996 was the beneficial owner of 15% or more of the shares of Common Stock outstanding on such date unless and until such Person, together with all affiliates and associates of such Person, becomes the beneficial owner of 25% or more of the shares of Common Stock then outstanding whereupon a Change in Control shall be deemed to have occurred; or

(F) any Person who becomes the beneficial owner of 20% or more, or, with respect to a Person described in clause (E) above, 25% or more, of the shares of Common Stock then outstanding as a result of a reduction in the number of shares of Common Stock outstanding due to the repurchase of shares of Common Stock by the Company unless and until such Person, after becoming aware that such Person has become the beneficial owner of 20% or more, or 25% or more, as the case may be, of the then outstanding shares of Common Stock, acquires beneficial ownership of additional shares of Common Stock representing 1% or more of the shares of Common Stock then outstanding, whereupon a Change in Control shall be deemed to have occurred or

(ii) individuals who, as of the date this Plan is approved by the Board, constitute the Board, and subsequently elected members of the Board whose election is approved or recommended by at least a majority of such current members or their successors whose election was so approved or recommended (other than any subsequently elected members whose initial assumption of office occurs as a result of an actual or threatened election contest with respect to the election or removal of directors or other actual or threatened solicitation of proxies or consents by or on behalf of a person other than the Board), cease for any reason to constitute at least a majority of such Board; or

(iii) approval by the stockholders of the Company of (A) a merger or consolidation of the Company with any other corporation, (B) the issuance of voting securities of the Company in connection with a merger or consolidation of the Company (or any Subsidiary) pursuant to applicable stock exchange requirements, or (C) sale or other disposition of all or substantially all of the assets of the Company or the acquisition of assets of another corporation (each, a “Business Combination”), unless, in each case, immediately following such Business Combination, all or substantially all of the individuals and entities who were the beneficial owners of the Common Stock outstanding immediately prior to such Business Combination beneficially own, directly or indirectly, more than 70% of the then outstanding shares of common stock and 70% of the combined voting power of the then outstanding voting securities entitled to vote generally in the election of directors, as the case may be, of the corporation resulting from such Business Combination (including, without limitation, a corporation which as a result of such transaction owns the Company or all or substantially all of the Company’s assets either directly or through one or more subsidiaries) in substantially the same proportions as their ownership, immediately prior to such Business Combination, of the Common Stock.

“Common Stock” means the Common Stock of the Company, par value $.01 per share, or such other class or kind of shares or other securities as may be applicable under Section 13 below.

“Company” means Ambac Financial Group, Inc., a Delaware corporation, or any successor to substantially all its business.

“Director Account” means the bookkeeping record established for each Non-Employee Director. A Director Account is established only for purposes of measuring the value of the Company’s obligation to a Non-Employee Director in respect of Director Stock Units and earnings thereon and not to segregate assets or to identify assets that may be used to settle Director Stock Units.

“Director Annual Stock Unit” means a restricted stock unit granted to a Non-Employee Director pursuant to Section 7 hereof.

“Director Five-Year Stock Unit” means a restricted stock unit granted to a Non-Employee Director pursuant to Section 6 hereof.

“Director Option” means a right to purchase shares of Common Stock granted to a Non-Employee Director pursuant to Section 7 hereof.

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“Director Stock Unit” means either a Director Five-Year Stock Unit or a Director Annual Stock Unit. A Director Stock Unit shall represent the right to receive one share of Common Stock upon satisfaction of the conditions to vesting and settlement specified in the Plan. Director Stock Units shall be settled exclusively in Common Stock.

“Effective Date” means the effective date of the Plan provided for in Section 11 below.

“Fair Market Value” means the average of the highest and the lowest quoted selling price of Common Stock as reported on the composite tape for securities listed on the New York Stock Exchange on the applicable valuation date or, if there were no sales on such valuation date, the average of the highest and the lowest quoted selling prices on said composite tape for the preceding business day.

“Non-Employee Director” means a member of the Board who is not an employee of the Company or any of its subsidiaries.

“Permanent Disability” means a physical or mental impairment rendering a Non-Employee Director substantially unable to function as a member of the Board for any period of six consecutive months. Any dispute as to whether a Non-Employee Director is Permanently Disabled shall be resolved by a physician mutually acceptable to the Non-Employee Director and the Company, whose decision shall be final and binding upon the Non-Employee Director and the Company.

“Person” means any individual, firm, corporation, partnership or other entity.

“Predecessor Plan” has the meaning set forth in Section 1 above.

“Subsidiary” means (i) a corporation or other entity with respect to which the Company, directly or indirectly, has the power, whether through the ownership of voting securities, by contract or otherwise, to elect at least a majority of the members of such corporation’s board of directors or analogous governing body, or (ii) any other corporation or other entity in which the Company, directly or indirectly, has an equity or similar interest and which the Committee designates as a Subsidiary for purposes of the Plan.

3. Administration

(a) Administration by the Board. The Plan shall be administered by the Board, which may adopt rules and regulations it considers necessary or appropriate to carry out the Plan’s purposes. The Board’s interpretation and construction of any Plan provision shall be final and conclusive. The Board may, but need not, from time to time delegate some or all of its authority under the Plan to a committee consisting of one or more members of the Board, any such delegation to be subject to the restrictions and limits that the Board specifies at the time of such delegation or thereafter. References in the Plan to the “Board” shall, to the extent consistent with the terms and limitations of any such delegation, be deemed to include a reference to any such committee to which the Board’s authority hereunder has been delegated.

(b) Award Certificate. The terms and conditions of each grant of Director Stock Units and Director Options under the Plan shall be embodied in an award agreement or award certificate which shall incorporate the Plan by reference, shall indicate the date on which the Director Stock Units or Director Options were granted and the number of Director Stock Units or Director Options granted on such date.

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4. Shares Available

Subject to the provisions of Section 13 below, the maximum number of shares of Common Stock which may be issued under the Plan (the “Section 4 Limit”) shall be 360,000 shares plus the number of shares of Common Stock that remain available for issuance under the Predecessor Plan as of the date the Plan is approved by the stockholders of the Company (increased by any shares of Common Stock subject to any Award (or portion thereof) outstanding under the Predecessor Plan on such date which lapses, expires or is otherwise terminated without the issuance of such shares or is settled by the delivery of consideration other than shares). Subject to Section 13 below, of the shares of Common Stock available for issuance under the Plan, no more than 225,000 shares may be issued upon settlement of Director Stock Units. For purposes of determining the number of shares of Common Stock that remain available for issuance, there shall be added back to the Section 4 Limit and again be available under the Plan any shares of Common Stock tendered to pay the exercise price of a Director Option. Either authorized and unissued shares of Common Stock or treasury shares may be delivered pursuant to the Plan.

5. Eligibility

Director Stock Units and Director Options shall be granted only to Non-Employee Directors.

6. Director Five-Year Stock Units

(a) Grants of Director Five-Year Stock Units. Director Five-Year Stock Units shall be awarded under the Plan as follows:

(i) On the date of the Annual Meeting coincident with or first succeeding a Non-Employee Director’s initial election to the Board (or re-election to the Board after a period during which the Non-Employee Director did not serve on the Board), the Non-Employee Director shall receive a grant of a number of Director Five-Year Stock Units calculated by dividing (x) $210,000, by (y) the Fair Market Value of one share of Common Stock on the date of the relevant Annual Meeting.

(ii) As of the date of the Annual Meeting that is closest in time to the applicable vesting date of any Director Five-Year Stock Units in accordance with Section 6(b)(i) below, or the vesting date of any restricted shares under the Predecessor Plan in accordance with Section 6(c)(i) thereof, a Non-Employee Director shall receive an additional grant of Director Five-Year Stock Units (an “Additional Grant”), provided that (A) the Annual Meeting as of which the Additional Grant is to be made occurs during the term of the Plan as set forth in Section 11 below, and (B) the Non-Employee Director is standing for re-election at such Annual Meeting. The number of Director Five-Year Stock Units included in such Additional Grant shall be calculated by dividing (x) $210,000, by (y) the Fair Market Value of one share of Common Stock on the date of the relevant Annual Meeting in connection with which the Additional Grant is made.

(b) Vesting; Accelerated Vesting; Deferral.

(i) Director Five-Year Stock Units granted in respect of a given Annual Meeting, and any additional Director Five-Year Stock Units credited to a Director Account in respect of earnings or other distributions on such Director Five-Year Stock Units as provided in Section 6(c), shall vest on the fifth anniversary of the date of grant and shall be settled as soon as practicable thereafter, provided that the Non-Employee Director shall have remained a member of the Board continuously from the date of grant until the earlier of (A) such fifth anniversary or (B) if the Non-Employee Director declines to stand for re-election to the Board at the Annual Meeting held in the fifth calendar year following the date of grant, the date of such Annual Meeting.

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(ii) Notwithstanding the provisions of Section 6(b)(i) above, all Director Five-Year Stock Units granted to a Non-Employee Director shall immediately vest upon the first to occur of (A) a Non-Employee Director ceasing to be a member of the Board as a result of retirement from the Board in accordance with the retirement policy then applicable to Board members, (B) a Non-Employee Director ceasing to be a member of the Board as a result of death or Permanent Disability or (C) subject to the following sentence, a Change in Control of the Company, and shall be settled as soon as practicable thereafter. Notwithstanding the preceding sentence, if any Person commences a tender offer for shares of Common Stock which, if successfully completed, would result in a Change in Control, then all Director Five-Year Stock Units granted to a Non-Employee Director shall vest and be settled immediately prior to the scheduled expiration of such tender offer, and the Company shall have instituted procedures to enable the Non-Employee Director, if he so desires, to tender the shares issued upon settlement of such Director Five-Year Stock Units into such offer.

(c) Forfeiture of Grant. Except as provided in Section 6(b)(ii) above, all Director Five-Year Stock Units shall be forfeited, and all rights of the Non-Employee Director to or with respect to such Director Stock Units shall terminate without any obligation on the part of the Company, upon the termination of a Non-Employee Director’s service as a member of the Board prior to the date on which such Director Five-Year Stock Units vest in accordance with Section 6(b)(i) above.

7. Annual Awards

(a) General. As of the date of each Annual Meeting, commencing with the 1997 Annual Meeting, each Non-Employee Director shall automatically receive an Award of Director Options or Director Annual Stock Units as provided in this Section 7. A Director Option shall entitle a Non-Employee Director to purchase a specified number of shares of Common Stock during a specified period at an exercise price per share of Common Stock determined as provided below. All Director Options provided for herein shall have the general terms and conditions set forth in Section 9 below.

(b) Grants of Director Options. As of the date of each Annual Meeting, commencing with the 1997 Annual Meeting, each Non-Employee Director shall automatically receive Director Options to purchase 3,750 shares of Common Stock provided that the Non-Employee Director shall continue to serve as a director of the Company after such Annual Meeting, provided, however, that beginning with the 2004 Annual Meeting, no further Awards of Director Options shall be made. The exercise price per share of Common Stock of each Director Option provided for in this Section 7(b) shall be the Fair Market Value of one share of Common Stock on the date of the relevant Annual Meeting.

(c) Grants of Director Annual Stock Units. As of the date of each Annual Meeting, commencing with the 2004 Annual Meeting, each Non-Employee Director shall automatically receive a number of Director Annual Stock Units determined by dividing (i) $60,000 by (ii) the Fair Market Value of one share of Common Stock on the date of the relevant Annual Meeting.

(d) Grants to New Directors. A Non-Employee Director who is initially elected or appointed to the Board other than in connection with an Annual Meeting shall receive, as of the date of such initial election or appointment, (i) if such appointment is made prior to the 2004 Annual Meeting, Director Options to purchase a number of shares determined by multiplying 3,750 by a fraction (the “Proration Fraction”), the numerator of which is the number of full months remaining until the next Annual Meeting (starting with the month following the date of election or appointment and counting the month in which the next Annual Meeting is scheduled to occur as a full month) and the denominator of which is 12 and (ii) if such appointment is made after the 2004 Annual Meeting, a number of Director Annual Stock Units calculated by multiplying (x) the number of Director Annual Stock Units that were awarded to each Non-Employee Director in connection with the immediately preceding Annual Meeting, times (y) the Proration Fraction. (If the date of the next Annual Meeting has not been scheduled at the time of the Non-Employee Director’s initial election or appointment, it shall be assumed that the next Annual

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Meeting will occur in the same month as the immediately preceding Annual Meeting.) The exercise price per share of Common Stock of each Director Option provided for in this Section 7(d) shall be the Fair Market Value of one share of Common Stock on the date of the Non-Employee Director’s election or appointment to the Board.

(e) Vesting. Annual Awards shall vest as of the first anniversary of the date of grant, assuming that the Non-Employee Director has continued to serve as a member of the Board until the earlier of (A) such first anniversary or (B) if the Non-Employee Director declines to stand for reelection to the Board at the Annual Meeting held in the calendar year following the date of grant, the date of such Annual Meeting. Notwithstanding the preceding sentence, all Annual Awards shall be considered fully vested upon the earlier to occur of (X) termination of the Non-Employee Director’s service on the Board by reason of death or Permanent Disability or (Y) a Change in Control, provided, however, that if any Person commences a tender offer for shares of Common Stock which, if successfully completed, would result in a Change in Control, then all Annual Awards granted to a Non-Employee Director shall vest and, in the case of Director Annual Stock Units, be settled, immediately prior to the scheduled expiration of such tender offer, and the Company shall have instituted procedures to enable the Non-Employee Director, if he so desires, to tender the shares issued upon the exercise of Director Options or upon the settlement of Director Annual Stock Units into such offer.

8. General Terms and Conditions of Director Stock Units

(a) Accounts. As of any date as of which a Non-Employee Director is granted Director Stock Units, the Director Account of such Non-Employee Director will be credited with the number of Director Stock Units so granted. In the event that the Company pays any cash or other dividend or makes any other distribution in respect of the Common Stock, each Director Account will be credited with an additional number of Director Stock Units (including fractions thereof) determined by dividing (A) the amount of cash, or the value (as determined by the Board) of any securities or other property, paid or distributed in respect of one outstanding share of Common Stock by (B) the Fair Market Value of a share of Common Stock for the date of such payment or distribution, and multiplying the result of such division by (C) the number of Director Stock Units that were credited to the Director Account immediately prior to the date of the dividend or other distribution. Credits shall be made effective as of the date of the dividend or other distribution in respect of the Common Stock.

(b) Notwithstanding the provisions of Sections 6(b)(i), 6(b)(ii) and 7(e) above, a Non-Employee Director may elect to defer settlement of any or all Director Stock Units to a date subsequent to the vesting date of such Director Stock Units, provided that no such deferral may extend beyond the earlier of (i) the Non-Employee Director’s termination of service on the Board or (ii) the Non-Employee’s death. Settlement of any deferred Director Stock Units shall be made on or as soon as practicable following the date specified by the Non-Employee Director in the relevant deferral election or, if applicable, the earlier of the dates specified in clauses (i) and (ii) of the preceding sentence.

(c) Delivery of Share Certificates. As soon as practicable following the vesting of Director Stock Units as provided in Sections 6(b)(i), 6(b)(ii) or 7(e) above, or the date for deferred settlement as provided in Section 8(b) above, Director Stock Units shall be settled either by: (i) delivery to the Non-Employee Director of a share certificate for the number of shares corresponding to such Director Stock Units (any fractional Director Stock Unit shall be rounded up to the next whole Director Stock Unit) or (ii) the transfer of the corresponding number of shares equal to the number of Director Stock Units being settled (any fractional Director Stock Unit shall be rounded up to the next whole Director Stock Unit) to the brokerage account designated by the Non-Employee Director to the Company in writing prior to settlement. Shares delivered in settlement of Director Stock Units shall be free of all such restrictions, except any that may be imposed under applicable law or the Company’s trading policy.

(d) No Stockholder Rights. The crediting of Director Stock Units to a Director Account shall not confer on the relevant Non-Employee Director any rights as a stockholder of the Company.

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9. General Terms and Conditions Director Options

(a) Option Term. Each Director Option shall expire on the date of the Annual Meeting held in the seventh calendar year following the date of grant, subject to earlier expiration as provided herein, provided, however, that Director Options granted to a Non-Employee Director whose initial election occurs other than in connection with an Annual Meeting shall be treated for this purpose as though they had been granted at the first Annual Meeting following such initial election.

(b) Vesting; Accelerated Vesting; Effect of Termination of Service.

(i) Exercisability. Director Options shall become exercisable upon vesting.

(ii) Exercise Following Termination of Service. Following termination of a Non-Employee Director’s service on the Board, the former Non-Employee Director (or the former Non-Employee Directors’ estate, personal representative or beneficiary, as the case may be) shall have the right, subject to the other terms and conditions hereof, to exercise all Director Options that had vested as of or in connection with the termination of service:

(A) at any time within three years after the date of termination of service, if such termination was by reason of death, Permanent Disability or retirement from the Board in accordance with the retirement policy then in effect for Board members, or

(B) in all other cases, at any time within one year after the date of termination of service; subject, in all case, to earlier expiration of the Director Option pursuant to Section 9(a) above.

(c) Notice of Exercise. Subject to the other terms and conditions of the Plan, a Non-Employee Director may exercise all or any portion of a vested Director Option by giving written notice of exercise to the Company or its designated agent, provided, however, that no fewer than 10 shares of Common Stock may be purchased upon any exercise of a Director Option unless the number of shares purchased at such time is the total number of shares in respect of which the Director Option is then exercisable, and provided, further, that in no event shall the Option be exercisable for a fractional share. The date of exercise of an Option shall be the later of (i) the date on which the Company or its agent receives such written notice or (ii) the date on which the conditions provided in Sections 9(d) and 9(e) below are satisfied.

(d) Payment. The exercise price of a Director Option may be paid in cash or previously owned shares or a combination thereof or by any other method approved by the Board.

(e) Limitation on Exercise. A Director Option shall not be exercisable unless the Common Stock subject thereto has been registered under the Securities Act of 1933, as amended (the “1933 Act”), and qualified under applicable state “blue sky” laws in connection with the offer and sale thereof, or the Company has determined that an exemption from registration under the 1933 Act and from qualification under such state “blue sky” laws is available.

(f) Issuance of Shares. Subject to the foregoing conditions, as soon as is reasonably practicable after its receipt of a proper notice of exercise and payment of the exercise price for the number of shares with respect to which a Director Option is exercised, the Company shall deliver to the exercising Non-Employee Director, at the principal office of the Company or at such other location as may be acceptable to the Company and the Non-Employee Director, one or more stock certificates for the appropriate number of shares of Common Stock issued in connection with such exercise. Such shares shall be fully paid and nonassessable and shall be issued in the name of the Non-Employee Director. Notwithstanding the foregoing, the Board in its discretion may, subject to rules and procedures as it may adopt or impose from time to time, provide Non-Employee Directors with the opportunity to defer receipt of shares of Common Stock issuable upon exercise of Director Options.

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10. Transferability

Director Stock Units (including interests in a Director Account) and Director Options may not be transferred, pledged, assigned or otherwise disposed of except by will or the laws of descent and distribution or pursuant to a domestic relations order, provided, however, that Director Options may be transferred to a member or members of a Non-Employee Director’s immediate family (as defined below) or to one or more trusts or partnerships established in whole or in part for the benefit of one or more of such immediate family members (collectively as “Permitted Transferees”), subject to such rules and procedures as may from time to time be adopted or imposed by the Board. If a Director Stock Option is transferred to a Permitted Transferee, it shall be further transferable only by will or the laws of descent and distribution or, for no consideration, to another Permitted Transferee of the Non-Employee Director. A Non-Employee Director shall notify the Company in writing prior to any proposed transfer of a Director Option to a Permitted Transferee and shall furnish the Company, upon request, with information concerning such Permitted Transferee’s financial condition and investment experience. For purposes of the Plan, a Non-Employee Director’s “immediate family” means any child, stepchild, grandchild, spouse, son-in-law or daughter-in-law and shall include adoptive relationships; provided, however, that if the Company adopts a different definition of “immediate family” (or similar term) in connection with the transferability of employee stock options awarded to employees of the Company, such definition shall apply, without further action of the Board, to the Plan.

11. Term

(a) Effective Date; Expiration. The Effective Date shall be the date of the 1997 Annual Meeting, assuming the Plan is approved by the stockholders of the Company at such Annual Meeting. Unless earlier terminated in accordance with Section 12 below, the Plan shall expire on the date of the Annual Meeting held in 2011. Grants of Director Five-Year Stock Units and Director Annual Stock Units shall be made in connection with the Annual Meeting held in 2011, and shall be the last grants made under the Plan. Expiration of the Plan in connection with the Annual Meeting held in 2011 shall not affect Awards made prior to such Annual Meeting, which Awards shall remain outstanding subject to the terms hereof.

(b) Coordination with Predecessor Plan. Awards of “Directors Shares” (as such term is defined in the Predecessor Plan) shall be made under the Predecessor Plan in connection with the 1997 Annual Meeting. Assuming the Plan is approved by the stockholders of the Company at the 1997 Annual Meeting, no further Awards shall be made under the Predecessor Plan after the Effective Date. Awards outstanding under the Predecessor Plan (including Awards made in connection with the 1997 Annual Meeting) shall remain outstanding after the Effective Date subject to the terms thereof.

12. Amendments

The Board may at any time and from time to time alter, amend, suspend or terminate the Plan in whole of in part, including without limitation to amend the provisions for determining the amount of Director Stock Units or Directors Options to be issued to a Non-Employee Director, provided, however, that:

(i) any amendment which under the requirements of applicable law or stock exchange rule must be approved by the stockholders of the Company shall not be effective unless and until such stockholder approval has been obtained in compliance with such law or rule;

(ii) except as provided in Section 13 below, the Board may not, without the approval of the Company’s stockholders, increase the number of shares available for issuance under the Plan pursuant to Section 4 above or the number of Director Stock Units or Director Options to be issued to any Non-Employee Director pursuant to Section 6 or Section 7 above or reduce the exercise price of a Director Option.

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No termination or amendment of the Plan that would adversely affect a Non-Employee Director’s rights under the Plan with respect to any Award made prior to such action shall be effective as to such Non-Employee Director unless he or she consents thereto.

13. Adjustment of and Changes in Shares

In the event of any merger, consolidation, recapitalization, reclassification, stock dividend, distribution of property, special cash dividend or other change in corporate structure affecting the shares, the Board, in its discretion, may make (i) such proportionate adjustments as it considers appropriate in the number and kind of shares authorized for issuance hereunder in order to preserve, but not increase, the benefits or potential benefits intended to be made available hereunder and/or (ii) such other adjustments as it deems appropriate. The Board’s determination as to what, if any, adjustments shall be made shall be final and binding on the Company and all Non-Employee Directors who receive grants under the Plan.

14. No Right to Re-election

Nothing in the Plan shall be deemed to create any obligation on the part of the Board to nominate any of its members for re-election by the Company’s stockholders, nor confer upon any Non-Employee Director the right to remain a member of the Board for any period of time, or at any particular rate of compensation.

15. Governing Law

The Plan and all agreements entered into under the Plan shall be construed in accordance with and governed by the laws of the State of Delaware.

16. No Restriction on Right of Company to Effect Corporate Changes

The Plan shall not affect in any way the right or power of the Company or its stockholders to make or authorize any or all adjustments, recapitalizations, reorganizations or other changes in the Company’s capital structure or its business, or any merger or consolidation of the Company, or any issue of stock or of options, warrants or rights to purchase stock or of bonds, debentures, preferred or prior preference stocks whose rights are superior to or affect the Common Stock or the rights thereof or which are convertible into or exchangeable for Common Stock, or the dissolution or liquidation of the Company, or any sale or transfer of all or any part of its assets or business, or any other corporate act or proceeding, whether of a similar character or otherwise.

17. Unfunded Plan

The Plan is unfunded. Prior to the payment or settlement of any Award of Director Stock Units or the exercise of any Director Options, nothing contained herein shall give any non-Employee Director any rights that are greater than those of a general creditor of the Company. In its sole discretion, the Board may authorize the creation of trusts or other arrangements to meet the obligations created under the Plan to deliver Common Stock with respect to Awards hereunder.

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EX-10.12

EXHIBIT 10.12

AMBAC FINANCIAL GROUP, INC.

1997 NON-EMPLOYEE DIRECTORS EQUITY PLAN,

AS AMENDED

Form of Notice of Award of Director Five-Year Restricted Stock Units

Ambac Financial Group, Inc. (the “Company”) has adopted the 1997 Non- Employee Directors Equity Plan, as amended (the “Plan”) to promote the long-term growth and financial success of the Company by attracting, motivating and retaining non-employee directors of outstanding ability and assisting the Company in promoting a greater identity of interest between the Company’s non-employee directors and its stockholders.

This Notice of Award sets forth the terms and conditions of an award of restricted stock units (“Director Five-Year Stock Units”) granted under Section 6 of the Plan. Annex A of this Notice of Award (“Annex A”) names the individual to whom the Director Five-Year Stock Units are granted (the “Participant”) and sets forth the number of Director Five-Year Stock Units subject to the award.

This Notice of Award and the Director Five-Year Stock Units granted hereby shall be subject to the Plan, the terms of which are incorporated herein by reference, and in the event of any conflict or inconsistency between the Plan and this Notice of Award, the Plan shall govern. Capitalized terms used herein without definition shall have the meanings assigned to them in the Plan, a copy of which has been furnished to the Participant.

1. Grant of Director Five-Year Stock Units.

Subject to the terms and conditions contained herein and in the Plan, the Company grants to the Participant, as of the date of grant indicated on Annex A (the “Date of Grant”), the number of Director Five-Year Stock Units indicated on Annex A.

2. Terms and Conditions of the Director Five-Year Stock Units.

The Director Five-Year Stock Units shall have the following terms and conditions:

(a) General. Each Director Five-Year Stock Unit shall represent the unsecured promise of the Company to transfer to the Participant, on the settlement date of such Unit and subject to the terms and conditions set forth in this Notice of Award, one share of the Company’s common stock, par value $0.01 per share (“Common Stock”).

Ambac 1997 Non-Employee Directors Equity Plan

Form of Notice of Award of Director Five-Year Stock Units

Page 2 of 8

(b) Director Account. As provided in the Plan, the Company will maintain a bookkeeping record for the Participant (the Participant’s “Director Account”) to which number of Director Five-Year Stock Units indicated on Annex A will be credited as of the Date of Grant.

(c) Vesting.

(i) Normal Vesting. The Director Five-Year Stock Units, including any additional Director Five-Year Stock Units credited to the Participant’s Director Account pursuant to Section 2(d) below, shall vest on the fifth anniversary of the Date of Grant, provided that the Participant shall have remained a member of the Company’s Board of Directors (the “Board”) continuously from the Date of Grant until the earlier of (A) such fifth anniversary or (B) if the Participant declines to stand for re-election to the Board at the annual meeting of the Company’s stockholders (an “Annual Meeting”) held in the fifth calendar year following the Date of Grant, the date of such Annual Meeting.

(ii) Accelerated Vesting. Notwithstanding clause (i) above, all of the Director Five-Year Stock Units, including any additional Director Five-Year Stock Units credited to the Participant’s Director Account pursuant to Section 2(d) below, shall immediately vest upon the first to occur of (A) the Participant’s ceasing to be a member of the Board as a result of retirement from the Board in accordance with the retirement policy then applicable to Board members, (B) the Participant’s ceasing to be a member of the Board as a result of death or Permanent Disability (as defined below) or (C) subject to the following sentence, a Change in Control of the Company. Notwithstanding the preceding sentence, if any Person commences a tender offer for shares of Common Stock which, if successfully completed, would result in a Change in Control, then all Director Five-Year Stock Units subject to this Notice of Award shall vest and be settled immediately prior to the scheduled expiration of such tender offer, and the Company shall have instituted procedures to enable the Participant, if the Participant so desires, to tender the shares issued upon settlement of such Director Five-Year Stock Units into such offer.

(iii) Forfeiture. Except in the case of accelerated vesting provided for in clause (ii) above, all of the Director Five-Year Stock Units subject to this Notice of Award shall be forfeited, and all rights of the Participant to or with respect to such Director Units shall terminate without any obligation on the part of the Company, if the Participant’s service as a member of the Board terminates prior to the fifth anniversary of the Date of Grant.

(d) Dividends and Distribution on Common Stock. If the Company pays any cash or other dividend or makes any other distribution in respect of the Common Stock, the Participant’s Director Account will be credited with an additional number of Director Units (including fractions thereof) determined by dividing (A) the amount of cash, or the value (as determined by the Board) of any securities or other property, paid or distributed in respect of one outstanding share of Common Stock by (B) the Fair Market Value (as defined below) of a share of Common Stock for the date of such payment or distribution, and multiplying the result of such

Ambac 1997 Non-Employee Directors Equity Plan

Form of Notice of Award of Director Five-Year Stock Units

Page 3 of 8

division by (C) the number of Director Five-Year Stock Units indicated on Annex A, plus the number of Director Five-Year Stock Units previously credited to the Participant’s Director Account in respect of such Director Five-Year Stock Units pursuant to this Section 2(d). Credits shall be made effective as of the date of the dividend or other distribution in respect of the Common Stock.

(e) Delivery of Share Certificates.

(i) Ordinary Settlement. Subject to Section 3(d)(ii), settlement of any Director Five-Year Stock Units shall occur promptly following the date on which such Director Five-Year Stock Units vest. Director Five-Year Stock Units will be settled, at the election of the Participant, either by:

(A) Delivery of a stock certificate or certificates representing the number of shares of Common Stock equal to the number of Director Five-Year Stock Units being settled (any fractional Director Five-Year Stock Units being rounded up to the next whole Director Five-Year Stock Unit). Certificates shall be issued in the name of the Participant (or of the person or persons to whom such Director Five-Year Stock Units were transferred by will or the laws of descent and distribution or pursuant to a Qualified Domestic Relations Order).

(B) The transfer of the corresponding number of shares of Common Stock equal to the number of Director Five-Year Stock Units being settled (or any fractional Director Five-Year Stock Unit being rounded up to the next whole Director Five-Year Stock Unit) to the brokerage account designated by the Participant to the Company in writing prior to settlement.

(ii) Deferred Settlement. Unless the Committee, in its sole discretion, determines otherwise, a Participant may irrevocably elect to defer settlement of any Director Five-Year Stock Units until a future date, provided that

(A) the Participant’s election is made no later than six months preceding the first year in which all or any portion of the Director Five-Year Stock Units are scheduled to vest as described in Annex A hereto,

AND

(B) no such settlement may extend beyond the earlier of (i) the Participant’s service on the Board or (ii) the Participant’s death.

Ambac 1997 Non-Employee Directors Equity Plan

Form of Notice of Award of Director Five-Year Stock Units

Page 4 of 8

A deferral election shall be made on a form provided to the Participant by the Company for this purpose.

(iii) Certain Exceptions Pursuant to Company Policy. Anything herein to the contrary notwithstanding, settlement of a Director Five-Year Stock Unit shall not occur on a date on which the Company’s policies then in effect prohibit the Participant from engaging in transactions in the Company’s securities. Instead, settlement shall occur on, or as promptly as practicable following, the first date that the Participant is again permitted to engage in transactions in the Company’s securities under the Company policies.

(iv) Transfer Restrictions on Common Stock. Shares of Common Stock issued upon the settlement of Director Five-Year Stock Units will not be subject to restrictions on transfer (except for any restrictions imposed by the federal securities laws or other applicable laws or regulations and for any restrictions under the Company’s trading policies applicable to employees).

(f) Transfer Restrictions on Director Five-Year Stock Units. Director Five-Year Stock Units may not be transferred, except by will or the laws of descent and distribution or pursuant to a Qualified Domestic Relations Order.

3. Tax Withholding.

The Company shall not, unless required or permitted by the Internal Revenue Code or applicable accounting rules or regulations, withhold shares of Common Stock that would otherwise be received by the Participant or deduct from cash payments to be made pursuant to or in connection with the settlement of the Director Five-Year Stock Units, any amount for the purpose of satisfying any Federal, state or local tax withholding requirement.

The Company, to the extent required or permitted by the Internal Revenue Code and/or applicable accounting rules, shall have the right, prior to the delivery of any certificates evidencing shares of Common Stock to be issued upon full or partial settlement of the Director Five-Year Stock Units, to require the Participant to remit to the Company any amount sufficient to satisfy any Federal, state or local tax withholding requirements. The Company may permit the Participant to satisfy, in whole or in part, such obligation to remit taxes, by directing the Company to withhold shares of Common Stock that would otherwise be received by the Participant, pursuant to such rules as the Board may establish from time to time. The Company shall also have the right to deduct from all cash payments made pursuant to or in connection with the Director Five-Year Stock Units any Federal, state or local taxes required to be withheld with respect to such payments.

Ambac 1997 Non-Employee Directors Equity Plan

Form of Notice of Award of Director Five-Year Stock Units

Page 5 of 8

4. No Restriction on Right to Effect Corporate Changes; No Right to Re-election;

Neither the Plan, this Notice of Award, the grant of the Director Five-Year Stock Units nor any action taken hereunder shall affect in any way the right or power of the Company or its stockholders to make or authorize any or all adjustments, recapitalizations, reorganizations or other changes in the Company’s capital structure or its business, or any merger or consolidation of the Company, or any issue of bonds, debentures, preferred or prior preference stocks ahead of or convertible into, or otherwise affecting the Common Stock or the rights thereof, or the dissolution or liquidation of the Company, or any sale or transfer of all or any part of its assets or business, or any other corporate act or proceeding, whether of a similar character or otherwise.

In addition, neither the Plan, this Notice of Award, the grant of the Director Five-Year Stock Units nor any action taken hereunder shall be deemed to create any obligation on the part of the Board to nominate the Participant for re-election by the Company’s stockholders, nor confer upon the Participant the right to remain a member of the Board for any period of time or at any particular rate of compensation.

5. Adjustment of and Changes in Shares.

In the event of any merger, consolidation, recapitalization, reclassification, stock dividend, special cash dividend, or other change in corporate structure affecting the Common Stock, the Board shall make such adjustments, if any, as it deems appropriate in the number and class of shares subject to the Director Five-Year Stock Units. The foregoing adjustments shall be determined by the Board in its sole discretion.

6. Preemption of Applicable Laws and Regulations.

Anything herein to the contrary notwithstanding, if, at any time specified herein for the issuance of shares of Common Stock to the Participant, any law, regulation or requirement of any governmental authority having jurisdiction shall require either the Company or the Participant to take any action in connection with the shares then to be issued, the issuance of such shares shall be deferred until such action shall have been taken.

7. Board Decisions Final.

Any dispute or disagreement which shall rise under, or as a result of, or pursuant to, or in connection with, this Notice of Award or the Director Five-Year Stock Units shall be determined by the Board, and any such determination or any other determination by the Board under or pursuant to this Notice of Award and any interpretation by the Board of the terms of the Director Five-Year Stock Units shall be final and binding on all persons affected thereby.

Ambac 1997 Non-Employee Directors Equity Plan

Form of Notice of Award of Director Five-Year Stock Units

Page 6 of 8

8. Amendments.

The Board shall have the power to alter or amend the terms of the Director Five-Year Stock Units as set forth herein, from time to time, in any manner consistent with the provisions of Section 11 of the Plan, and any alteration or amendment of the terms of the Director Five-Year Stock Units by the Board shall, upon adoption, become and be binding on all persons affected thereby without requirement for consent or other action with respect thereto by any such person. The Board shall give written notice to the Participant of any such alteration or amendment as promptly as practicable after the adoption thereof. The foregoing shall not restrict the ability of the Participant and the Company by mutual consent to alter or amend the terms of the Director Five-Year Stock Units in any manner which is consistent with the Plan and approved by the Board.

9. Notice Requirements.

Any notice which either party hereto may be required or permitted to give to the other shall be in writing. Such notice may be delivered to the Company personally or by mail, postage prepaid, addressed as follows: Ambac Financial Group, Inc., One State Street Plaza, New York, New York 10004, attention: Corporate Secretary, or at such other address as the Company, by notice to the Participant, may designate in writing from time to time, and to the Participant at the Participant’s address as shown on the records of the Company or at such other address as the Participant, by notice to the Company, may designate in writing from time to time.

10. Governing Law.

The terms and conditions stated herein are to be governed by, and construed in accordance with, the laws of the State of Delaware.

11. Entire Agreement; Headings.

This Notice of Award (which includes Annex A) and the other related documents expressly referred to herein set forth the entire agreement and understanding between the parties hereto and supersede all prior agreements and understandings relating to the subject matter hereof. In the event of a discrepancy or inconsistency in the number of Director Five-Year Stock Units, the Date of Grant, the vesting of the Director Five-Year Stock Units or any other term in this Notice of Award and the provisions of the Plan authorizing the grant of the Director Five-Year Stock Units, the provisions of the Plan shall control and the Company shall have the right in its sole discretion, to replace the Notice of Award with a correct version or any portion thereof (including any portion of Annex A). The headings of Sections and subsections herein are included solely for convenience of reference and shall not affect the meaning of any of the provisions of this Notice.

Ambac 1997 Non-Employee Directors Equity Plan

Form of Notice of Award of Director Five-Year Stock Units

Page 7 of 8

12. Definitions.

For purposes hereof, the following terms shall have the meanings specified below.

(a) Change in Control. “Change in Control” means:

(i) the acquisition by any Person of beneficial ownership (within the meaning of Rule 13d-3 promulgated under the Exchange Act) of 20% or more of the Common Stock then outstanding, but shall not include any such acquisition by:

(A) the Company;

(B) any Subsidiary of the Company;

(C) any employee benefit plan of the Company or of any Subsidiary of the Company;

(D) any Person or entity organized, appointed or established by the Company for or pursuant to the terms of any such plan;

(E) any Person who as of January 31, 1996 was the beneficial owner of 15% or more of the shares of Common Stock outstanding on such date unless and until such Person, together with all affiliates and associates of such Person, becomes the beneficial owner of 25% or more of the shares of Common Stock then outstanding whereupon a Change in Control shall be deemed to have occurred; or

(F) any Person who becomes the Beneficial Owner of 20% or more, or, with respect to a Person described in clause (E) above, 25% or more, of the shares of Common Stock then outstanding as a result of a reduction in the number of shares of Common Stock outstanding due to the repurchase of shares of Common Stock by the Company unless and until such Person, after becoming aware that such Person has become the beneficial owner of 20% or more, or 25% or more, as the case may be, of the then outstanding shares of Common Stock, acquires beneficial ownership of additional shares of Common Stock representing 1% or more of the shares of Common Stock then outstanding, whereupon a Change in Control shall be deemed to have occurred;

(ii) individuals who, as of the date the Plan was approved by the Board, constituted the Board, and subsequently elected members of the Board whose election is approved or recommended by at least a majority of such current members or their successors whose election was so approved or recommended (other than any subsequently elected members whose initial assumption of office occurs as a result of an

Ambac 1997 Non-Employee Directors Equity Plan

Form of Notice of Award of Director Five-Year Stock Units

Page 8 of 8

actual or threatened election contest with respect to the election or removal of directors or other actual or threatened solicitation of proxies or consents by or on behalf of a person other than the Board), cease for any reason to constitute at least a majority of such Board; or

(iii) approval by the stockholders of the Company of (A) a merger or consolidation of the Company with any other corporation, (B) the issuance of voting securities of the Company in connection with a merger or consolidation of the Company (or any Subsidiary) pursuant to applicable stock exchange requirements, or (C) sale or other disposition of all or substantially all of the assets of the Company or the acquisition of assets of another corporation (each, a “Business Combination”), unless, in each case, immediately following such Business Combination, all or substantially all of the individuals and entities who were the beneficial owners of the Common Stock outstanding immediately prior to such Business Combination beneficially own, directly or indirectly, more than 70% of the then outstanding shares of common stock and 70% of the combined voting power of the then outstanding voting securities entitled to vote generally in the election of directors, as the case may be, of the corporation resulting from such Business Combination (including, without limitation, a corporation which as a result of such transaction owns the Company or all or substantially all of the Company’s assets either directly or through one or more subsidiaries) in substantially the same proportions as their ownership, immediately prior to such Business Combination, of the Common Stock.

(b) Permanent Disability. “Permanent Disability” means a physical or mental impairment rendering the Participant substantially unable to function as a member of the Board for any period of six consecutive months. Any dispute as to whether the Participant is Permanently Disabled shall be resolved by a physician mutually acceptable to the Participant and the Company, whose decision shall be final and binding upon the Participant and the Company.

ANNEX A TO THE

FORM OF DIRECTOR FIVE-YEAR STOCK UNITS

AWARD AGREEMENT

DIRECTOR FIVE-YEAR STOCK UNITS AWARD

Participant:	[Name]	Social Security No.:
No. of Shares:	_______	Vesting Date:	______
Date of Grant:

EX-10.13

EXHIBIT 10.13

AMBAC FINANCIAL GROUP, INC.

1997 NON-EMPLOYEE DIRECTORS EQUITY PLAN,

AS AMENDED

Form of Notice of Award of Director Annual Stock Units

Ambac Financial Group, Inc. (the “Company”) has adopted the 1997 Non- Employee Directors Equity Plan, as amended (the “Plan”) to promote the long-term growth and financial success of the Company by attracting, motivating and retaining non-employee directors of outstanding ability and assisting the Company in promoting a greater identity of interest between the Company’s non-employee directors and its stockholders.

This Notice of Award sets forth the terms and conditions of an award of restricted stock units (“Director Annual Stock Units”) granted under Section 7 of the Plan. Annex A of this Notice of Award (“Annex A”) names the individual to whom the Director Annual Stock Units are granted (the “Participant”) and sets forth the number of Director Annual Stock Units subject to the award.

This Notice of Award and the Director Annual Stock Units granted hereby shall be subject to the Plan, the terms of which are incorporated herein by reference, and in the event of any conflict or inconsistency between the Plan and this Notice of Award, the Plan shall govern. Capitalized terms used herein without definition shall have the meanings assigned to them in the Plan, a copy of which has been furnished to the Participant.

1. Grant of Director Annual Stock Units.

Subject to the terms and conditions contained herein and in the Plan, the Company grants to the Participant, as of the date of grant indicated on Annex A (the “Date of Grant”), the number of Director Annual Stock Units indicated on Annex A.

2. Terms and Conditions of the Director Annual Stock Units.

The Director Annual Stock Units shall have the following terms and conditions:

(a) General. Each Director Annual Stock Unit shall represent the unsecured promise of the Company to transfer to the Participant, on the settlement date of such Unit and subject to the terms and conditions set forth in this Notice of Award, one share of the Company’s common stock, par value $0.01 per share (“Common Stock”).

Ambac 1997 Non-Employee Directors Equity Plan

Form of Notice of Award of Director Annual Stock Units

Page 2 of 8

(b) Director Account. As provided in the Plan, the Company will maintain a bookkeeping record for the Participant (the Participant’s “Director Account”) to which number of Director Annual Stock Units indicated on Annex A will be credited as of the Date of Grant.

(c) Vesting.

(i) Normal Vesting. The Director Annual Stock Units, including any additional Director Annual Stock Units credited to the Participant’s Director Account pursuant to Section 2(d) below, shall vest on the first anniversary of the Date of Grant, provided that the Participant shall have remained a member of the Company’s Board of Directors (the “Board”) continuously from the Date of Grant until the earlier of (A) such first anniversary or (B) if the Participant declines to stand for re-election to the Board at the annual meeting of the Company’s stockholders (an “Annual Meeting”) held in the first calendar year following the Date of Grant, the date of such Annual Meeting.

(ii) Accelerated Vesting. Notwithstanding clause (i) above, all of the Director Annual Stock Units, including any additional Director Annual Stock Units credited to the Participant’s Director Account pursuant to Section 2(d) below, shall immediately vest upon the earlier to occur of (X) the Participant’s ceasing to be a member of the Board as a result of death or Permanent Disability (as defined below) or (Y) subject to the following sentence, a Change in Control of the Company. Notwithstanding the preceding sentence, if any Person commences a tender offer for shares of Common Stock which, if successfully completed, would result in a Change in Control, then all Director Annual Stock Units subject to this Notice of Award shall vest and be settled immediately prior to the scheduled expiration of such tender offer, and the Company shall have instituted procedures to enable the Participant, if the Participant so desires, to tender the shares issued upon settlement of such Director Annual Stock Units into such offer.

(iii) Forfeiture. Except in the case of accelerated vesting provided for in clause (ii) above, all of the Director Annual Stock Units subject to this Notice of Award shall be forfeited, and all rights of the Participant to or with respect to such Director Units shall terminate without any obligation on the part of the Company, if the Participant’s service as a member of the Board terminates prior to the vesting of the Director Annual Stock Units.

(d) Dividends and Distribution on Common Stock. If the Company pays any cash or other dividend or makes any other distribution in respect of the Common Stock, the Participant’s Director Account will be credited with an additional number of Director Units (including fractions thereof) determined by dividing (A) the amount of cash, or the value (as determined by the Board) of any securities or other property, paid or distributed in respect of one outstanding share of Common Stock by (B) the Fair Market Value (as defined below) of a share of Common Stock for the date of such payment or distribution, and multiplying the result of such division by (C) the number of Director Annual Stock Units indicated on Annex A, plus the number of Director Annual Stock Units previously credited to the Participant’s Director Account

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Form of Notice of Award of Director Annual Stock Units

Page 3 of 8

in respect of such Director Annual Stock Units pursuant to this Section 2(d). Credits shall be made effective as of the date of the dividend or other distribution in respect of the Common Stock.

(e) Delivery of Share Certificates.

(i) Ordinary Settlement. Subject to Section 3(d)(ii), settlement of any Director Annual Stock Units shall occur promptly following the date on which such Director Annual Stock Units vest. Director Annual Stock Units will be settled, at the election of the Participant, either by:

(A) Delivery of a stock certificate or certificates representing the number of shares of Common Stock equal to the number of Director Annual Stock Units being settled (any fractional Director Annual Stock Units being rounded up to the next whole Director Annual Stock Unit). Certificates shall be issued in the name of the Participant (or of the person or persons to whom such Director Annual Stock Units were transferred by will or the laws of descent and distribution or pursuant to a Qualified Domestic Relations Order).

(B) The transfer of the corresponding number of shares of Common Stock equal to the number of Director Annual Stock Units being settled (or any fractional Director Annual Stock Unit being rounded up to the next whole Director Annual Stock Unit) to the brokerage account designated by the Participant to the Company in writing prior to settlement.

(ii) Deferred Settlement. Unless the Committee, in its sole discretion, determines otherwise, a Participant may irrevocably elect to defer settlement of any Director Annual Stock Units until a future date, provided that

(A) the Participant’s election is made prior to the grant of the Director Annual Stock Units described in Annex A hereto,

AND

(B) no such settlement may extend beyond the earlier of (i) the Participant’s service on the Board or (ii) the Participant’s death.

A deferral election shall be made on a form provided to the Participant by the Company for this purpose.

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Form of Notice of Award of Director Annual Stock Units

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(iii) Certain Exceptions Pursuant to Company Policy. Anything herein to the contrary notwithstanding, settlement of a Director Annual Stock Unit shall not occur on a date on which the Company’s policies then in effect prohibit the Participant from engaging in transactions in the Company’s securities. Instead, settlement shall occur on, or as promptly as practicable following, the first date that the Participant is again permitted to engage in transactions in the Company’s securities under the Company policies.

(iv) Transfer Restrictions on Common Stock. Shares of Common Stock issued upon the settlement of Director Annual Stock Units will not be subject to restrictions on transfer (except for any restrictions imposed by the federal securities laws or other applicable laws or regulations and for any restrictions under the Company’s trading policies applicable to employees).

(f) Transfer Restrictions on Director Annual Stock Units. Director Annual Stock Units may not be transferred, except by will or the laws of descent and distribution or pursuant to a Qualified Domestic Relations Order.

3. Tax Withholding.

The Company shall not, unless required or permitted by the Internal Revenue Code or applicable accounting rules or regulations, withhold shares of Common Stock that would otherwise be received by the Participant or deduct from cash payments to be made pursuant to or in connection with the settlement of the Director Annual Stock Units, any amount for the purpose of satisfying any Federal, state or local tax withholding requirement.

The Company, to the extent required or permitted by the Internal Revenue Code and/or applicable accounting rules, shall have the right, prior to the delivery of any certificates evidencing shares of Common Stock to be issued upon full or partial settlement of the Director Annual Stock Units, to require the Participant to remit to the Company any amount sufficient to satisfy any Federal, state or local tax withholding requirements. The Company may permit the Participant to satisfy, in whole or in part, such obligation to remit taxes, by directing the Company to withhold shares of Common Stock that would otherwise be received by the Participant, pursuant to such rules as the Board may establish from time to time. The Company shall also have the right to deduct from all cash payments made pursuant to or in connection with the Director Annual Stock Units any Federal, state or local taxes required to be withheld with respect to such payments.

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Form of Notice of Award of Director Annual Stock Units

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4. No Restriction on Right to Effect Corporate Changes; No Right to Re-election;

Neither the Plan, this Notice of Award, the grant of the Director Annual Stock Units nor any action taken hereunder shall affect in any way the right or power of the Company or its stockholders to make or authorize any or all adjustments, recapitalizations, reorganizations or other changes in the Company’s capital structure or its business, or any merger or consolidation of the Company, or any issue of bonds, debentures, preferred or prior preference stocks ahead of or convertible into, or otherwise affecting the Common Stock or the rights thereof, or the dissolution or liquidation of the Company, or any sale or transfer of all or any part of its assets or business, or any other corporate act or proceeding, whether of a similar character or otherwise.

In addition, neither the Plan, this Notice of Award, the grant of the Director Annual Stock Units nor any action taken hereunder shall be deemed to create any obligation on the part of the Board to nominate the Participant for re-election by the Company’s stockholders, nor confer upon the Participant the right to remain a member of the Board for any period of time or at any particular rate of compensation.

5. Adjustment of and Changes in Shares.

In the event of any merger, consolidation, recapitalization, reclassification, stock dividend, special cash dividend, or other change in corporate structure affecting the Common Stock, the Board shall make such adjustments, if any, as it deems appropriate in the number and class of shares subject to the Director Annual Stock Units. The foregoing adjustments shall be determined by the Board in its sole discretion.

6. Preemption of Applicable Laws and Regulations.

Anything herein to the contrary notwithstanding, if, at any time specified herein for the issuance of shares of Common Stock to the Participant, any law, regulation or requirement of any governmental authority having jurisdiction shall require either the Company or the Participant to take any action in connection with the shares then to be issued, the issuance of such shares shall be deferred until such action shall have been taken.

7. Board Decisions Final.

Any dispute or disagreement which shall rise under, or as a result of, or pursuant to, or in connection with, this Notice of Award or the Director Annual Stock Units shall be determined by the Board, and any such determination or any other determination by the Board under or pursuant to this Notice of Award and any interpretation by the Board of the terms of the Director Annual Stock Units shall be final and binding on all persons affected thereby.

Ambac 1997 Non-Employee Directors Equity Plan

Form of Notice of Award of Director Annual Stock Units

Page 6 of 8

8. Amendments.

The Board shall have the power to alter or amend the terms of the Director Annual Stock Units as set forth herein, from time to time, in any manner consistent with the provisions of Section 11 of the Plan, and any alteration or amendment of the terms of the Director Annual Stock Units by the Board shall, upon adoption, become and be binding on all persons affected thereby without requirement for consent or other action with respect thereto by any such person. The Board shall give written notice to the Participant of any such alteration or amendment as promptly as practicable after the adoption thereof. The foregoing shall not restrict the ability of the Participant and the Company by mutual consent to alter or amend the terms of the Director Annual Stock Units in any manner which is consistent with the Plan and approved by the Board.

9. Notice Requirements.

Any notice which either party hereto may be required or permitted to give to the other shall be in writing. Such notice may be delivered to the Company personally or by mail, postage prepaid, addressed as follows: Ambac Financial Group, Inc., One State Street Plaza, New York, New York 10004, attention: Corporate Secretary, or at such other address as the Company, by notice to the Participant, may designate in writing from time to time, and to the Participant at the Participant’s address as shown on the records of the Company or at such other address as the Participant, by notice to the Company, may designate in writing from time to time.

10. Governing Law.

The terms and conditions stated herein are to be governed by, and construed in accordance with, the laws of the State of Delaware.

11. Entire Agreement; Headings.

This Notice of Award (which includes Annex A) and the other related documents expressly referred to herein set forth the entire agreement and understanding between the parties hereto and supersede all prior agreements and understandings relating to the subject matter hereof. In the event of a discrepancy or inconsistency in the number of Director Annual Stock Units, the Date of Grant, the vesting of the Director Annual Stock Units or any other term in this Notice of Award and the provisions of the Plan authorizing the grant of the Director Annual Stock Units, the provisions of the Plan shall control and the Company shall have the right in its sole discretion, to replace the Notice of Award with a correct version or any portion thereof (including any portion of Annex A). The headings of Sections and subsections herein are included solely for convenience of reference and shall not affect the meaning of any of the provisions of this Notice.

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Form of Notice of Award of Director Annual Stock Units

Page 7 of 8

12. Definitions.

For purposes hereof, the following terms shall have the meanings specified below.

(a) Change in Control. “Change in Control” means:

(i) the acquisition by any Person of beneficial ownership (within the meaning of Rule 13d-3 promulgated under the Exchange Act) of 20% or more of the Common Stock then outstanding, but shall not include any such acquisition by:

(A) the Company;

(B) any Subsidiary of the Company;

(C) any employee benefit plan of the Company or of any Subsidiary of the Company;

(D) any Person or entity organized, appointed or established by the Company for or pursuant to the terms of any such plan;

(E) any Person who as of January 31, 1996 was the beneficial owner of 15% or more of the shares of Common Stock outstanding on such date unless and until such Person, together with all affiliates and associates of such Person, becomes the beneficial owner of 25% or more of the shares of Common Stock then outstanding whereupon a Change in Control shall be deemed to have occurred; or

(F) any Person who becomes the Beneficial Owner of 20% or more, or, with respect to a Person described in clause (E) above, 25% or more, of the shares of Common Stock then outstanding as a result of a reduction in the number of shares of Common Stock outstanding due to the repurchase of shares of Common Stock by the Company unless and until such Person, after becoming aware that such Person has become the beneficial owner of 20% or more, or 25% or more, as the case may be, of the then outstanding shares of Common Stock, acquires beneficial ownership of additional shares of Common Stock representing 1% or more of the shares of Common Stock then outstanding, whereupon a Change in Control shall be deemed to have occurred;

(ii) individuals who, as of the date the Plan was approved by the Board, constituted the Board, and subsequently elected members of the Board whose election is approved or recommended by at least a majority of such current members or their successors whose election was so approved or recommended (other than any subsequently elected members whose initial assumption of office occurs as a result of an

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Form of Notice of Award of Director Annual Stock Units

Page 8 of 8

actual or threatened election contest with respect to the election or removal of directors or other actual or threatened solicitation of proxies or consents by or on behalf of a person other than the Board), cease for any reason to constitute at least a majority of such Board; or

(iii) approval by the stockholders of the Company of (A) a merger or consolidation of the Company with any other corporation, (B) the issuance of voting securities of the Company in connection with a merger or consolidation of the Company (or any Subsidiary) pursuant to applicable stock exchange requirements, or (C) sale or other disposition of all or substantially all of the assets of the Company or the acquisition of assets of another corporation (each, a “Business Combination”), unless, in each case, immediately following such Business Combination, all or substantially all of the individuals and entities who were the beneficial owners of the Common Stock outstanding immediately prior to such Business Combination beneficially own, directly or indirectly, more than 70% of the then outstanding shares of common stock and 70% of the combined voting power of the then outstanding voting securities entitled to vote generally in the election of directors, as the case may be, of the corporation resulting from such Business Combination (including, without limitation, a corporation which as a result of such transaction owns the Company or all or substantially all of the Company’s assets either directly or through one or more subsidiaries) in substantially the same proportions as their ownership, immediately prior to such Business Combination, of the Common Stock.

(b) Permanent Disability. “Permanent Disability” means a physical or mental impairment rendering the Participant substantially unable to function as a member of the Board for any period of six consecutive months. Any dispute as to whether the Participant is Permanently Disabled shall be resolved by a physician mutually acceptable to the Participant and the Company, whose decision shall be final and binding upon the Participant and the Company.

ANNEX A TO THE

FORM OF DIRECTOR ANNUAL STOCK UNITS

AWARD AGREEMENT

FORM OF DIRECTOR ANNUAL STOCK UNITS AWARD

Participant: [Name]	Social Security No.:
No. of Shares:	Vesting Date:
Date of Grant:

EX-12.01

EXHIBIT 12.01

Ambac Financial Group, Inc.

Ratio of Earnings to Fixed Charges

(In thousands, except ratios)

	Years Ended December 31,
	2004		2003		2002		2001		2000
Earnings:
Pre-tax income from continuing operations	$	976,782	$	849,589	$	563,331	$	568,014	$	481,880
Interest expense		54,322		54,201		43,724		40,442		37,477
Portion of rentals deemed to be interest		2,836		2,478		2,126		1,972		1,859
Earnings	$	1,033,940	$	906,268	$	609,181	$	610,428	$	521,216
Fixed Charges:
Interest Expense	$	54,322	$	54,201	$	43,724	$	40,442	$	37,477
Portion of rentals deemed to be interest		2,836		2,478		2,126		1,972		1,859
Fixed Charges	$	57,158	$	56,679	$	45,850	$	42,414	$	39,336
Ratio of earnings to fixed charges		18.1		16.0		13.3		14.4		13.3

EX-13.01

Exhibit 13.01

Financial Highlights

Ambac Financial Group, Inc. and Subsidiaries

(Dollars in millions, except per share amounts)	2004			2003			2002			2001			2000
Statement of Operations Highlights
Gross premiums written	$	1,047.8		$	1,143.7		$	904.0		$	683.3		$	483.1
Net premiums earned and other credit enhancement fees		764.0			667.3			500.3			400.4			323.4
Net investment income		361.1			321.1			297.3			267.8			241.0
Interest income from investment and payment agreements		198.8			212.0			255.0			249.9			303.2
Financial services - other revenues		35.8			20.6			17.4			24.2			29.7
Total revenue		1,406.7			1,272.2			958.6			946.8			891.5
Losses and loss expenses		69.6			53.4			26.7			20.0			15.0
Financial guarantee underwriting and operating expenses		106.6			92.0			76.5			68.0			55.2
Interest expense from investment and payment agreements		168.9			196.3			231.3			235.4			283.0
Financial services - other expenses		14.7			12.1			9.9			8.9			12.2
Interest expense		54.3			54.2			43.7			40.4			37.5
Net income		724.6			618.9			432.6			432.9			366.2
Net income per share:
Basic		6.61			5.81			4.08			4.10			3.49
Diluted		6.53			5.66			3.97			3.97			3.41
Return on equity		15.6	%		15.7	%		13.1	%		15.5	%		15.9	%
Cash dividends declared per common share		0.470			0.420			0.380			0.340			0.307
Balance Sheet Highlights
Total investments, at fair value	$	14,768.4		$	13,965.4		$	12,539.3		$	10,287.9		$	8,323.9
Prepaid reinsurance		297.3			325.5			296.1			267.7			242.6
Total assets		18,585.3			16,747.3			15,355.5			12,339.5			10,120.2
Unearned premiums		2,778.9			2,545.5			2,128.8			1,780.3			1,546.3
Losses and loss expense reserve		254.1			189.4			172.1			151.1			132.4
Obligations under investment agreements, investment repurchase agreements and payment agreements		7,080.7			7,076.4			7,282.9			5,511.9			4,892.9
Long-term debt		1,866.2			980.9			616.7			619.3			424.1
Total stockholders’ equity		5,024.5			4,254.6			3,625.2			2,983.7			2,596.1

(Dollars in millions, except per share amounts)	1999			1998			1997			1996			1995
Statement of Operations Highlights
Gross premiums written	$	445.2		$	361.0		$	286.2		$	247.2		$	193.3
Net premiums earned and other credit enhancement fees		268.3			213.0			154.0			136.6			111.8
Net investment income		209.3			186.2			159.7			144.9			131.0
Interest income from investment and payment agreements		323.2			281.9			200.3			165.2			137.4
Financial services - other revenues		16.9			20.4			12.1			11.2			3.4
Total revenue		821.8			709.8			559.0			607.4			409.9
Losses and loss expenses		11.0			6.0			2.9			3.8			3.4
Financial guarantee underwriting and operating expenses		48.8			46.7			40.7			37.2			34.5
Interest expense from investment and payment agreements		299.5			263.6			186.7			154.5			127.7
Financial services - other expenses		12.3			20.3			15.2			8.5			7.8
Interest expense		36.5			32.8			21.3			20.9			20.9
Net income		307.9			254.0			223.0			276.3			167.6
Net income per share:
Basic		2.94			2.42			2.12			2.63			1.59
Diluted		2.88			2.37			2.09			2.60			1.58
Return on equity		15.0	%		12.8	%		12.8	%		18.3	%		13.8	%
Cash dividends declared per common share		0.280			0.253			0.230			0.205			0.185
Balance Sheet Highlights
Total investments, at fair value	$	8,962.5		$	8,748.4		$	6,915.1		$	5,200.5		$	4,441.6
Prepaid reinsurance		218.0			199.9			183.5			168.8			153.4
Total assets		11,344.6			11,212.3			8,291.7			5,876.4			5,309.3
Unearned premiums		1,431.1			1,294.2			1,179.0			991.2			903.0
Losses and loss expense reserve		121.0			115.8			103.3			60.6			66.0
Obligations under investment agreements, investment repurchase agreements and payment agreements		6,140.3			5,956.8			4,321.0			2,754.6			2,426.9
Long-term debt		424.0			423.9			223.9			223.8			223.7
Total stockholders’ equity		2,018.5			2,096.1			1,872.5			1,615.0			1,404.0

Management’s Discussion and Analysis

of Financial Condition and Results of Operations

OVERVIEW

Ambac Financial Group, Inc. is a holding company whose subsidiaries provide financial guarantees and financial services to clients in both the public and private sectors around the world. Our diluted earnings per share was $6.53 for 2004, a 15% increase compared with 2003. Ambac recorded record revenues of $1.4 billion, an 11% increase as compared to 2003. Return on average shareholders’ equity was 15.6%. Our results reflect strong production in both our financial guarantee and financial services segments.

Ambac’s principal operating subsidiary, Ambac Assurance Corporation, a leading provider of financial guarantees for public finance and structured finance obligations, has earned triple-A ratings, the highest ratings available from Moody’s Investors Service, Inc., Standard & Poor’s Ratings Services, Fitch Inc., and Rating and Investment Information, Inc. Ambac Assurance provides financial guarantees for bond issues and other forms of debt financing. Financial guarantee insurance is a promise to pay scheduled interest and principal if the issuer fails to meet its obligations. A bond guaranteed by Ambac receives triple-A ratings, typically resulting in lower financing costs for the issuer and generally makes the issue more marketable, both in the primary and secondary markets.

Ambac reports its financial guarantee business segment broken out by three principal markets: Public Finance, Structured Finance and International Finance. Public Finance includes all U.S. municipal issuance including general obligations, lease and tax-backed obligations, health care, public utilities, transportation and higher education, as well as certain infrastructure privatization transactions, such as stadium financings, military housing and student housing. Structured Finance covers U.S. structured finance transactions including, mortgage-backed securities and other consumer asset-backed securities, commercial asset-backed securities, collateralized debt obligations, investor-owned utilities and asset-backed commercial paper conduits. International Finance covers both infrastructure privatization transactions and the structured finance markets outside of the U.S. Increased net premiums earned and other credit enhancement fee revenues drove growth in our financial guarantee segment. This resulted from continued growth in revenues primarily in the United States, Western Europe and Australia.

Management believes that the financial guarantee business thrives on economic cycles. For example, a strong economic environment with a good or improving credit environment is beneficial to our financial guarantee portfolio. However, such conditions, if in place for an extended period of time, will reduce credit spreads and result in lower pricing. Conversely, in a deteriorating credit environment, credit spreads widen and pricing for our product improves. However, if the weakening environment is prolonged, the stresses on our portfolio could result in claims payments in excess of normal or historical expectations. Ambac’s management believes that its business is well positioned to withstand, and in fact prosper, within the normal economic and business cycles witnessed over the past several years. Further, Ambac’s financial guarantee business today enjoys a strong competitive position in a variety of product segments on a global scale and is well positioned for further geographic product expansion. Management believes that geographic product expansion will be driven, over the long term, by critical infrastructure needs worldwide and the expansion of global credit markets.

Ambac’s Financial Services segment provides financial and investment products including investment agreements, interest rate swaps, total return swaps and funding conduits, principally to clients of the financial guarantee business, which includes municipalities and other public entities, health care organizations, and asset-backed and structured finance issuers. Ambac focuses on these businesses due to the complementary nature of the products to its financial guarantee product. Financial Services growth was fueled by improved interest spreads in our investment agreement business and higher derivative product revenues.

FORWARD-LOOKING STATEMENTS

Materials in this annual report may contain information that includes or is based upon forward-looking statements within the meaning of the Securities Litigation Reform Act of 1995. Forward-looking statements are not historical facts but instead represent Ambac’s belief regarding future events, many of which, by their nature, are inherently uncertain and outside our control. You can identify these statements by the fact that they do not relate strictly to historical or current facts and relate to future plans or objectives and results.

Any or all of Ambac’s forward-looking statements here or in other publications may turn out to be wrong and are based on current expectations and the current economic environment. Ambac’s actual results may vary materially, and there are no guarantees about the performance of Ambac’s securities. Among factors that could cause actual results to differ materially are: (1) changes in the economic, credit or interest rate environment in the United States and abroad; (2) the level of activity within the national and worldwide debt markets; (3) competitive conditions and pricing levels; (4) legislative and regulatory developments; (5) changes in tax laws; (6) the policies and actions of the United States and other governments; and (7) other risks and uncertainties that have not been identified at this time. Ambac is not obligated to publicly correct or update any forward-looking statement if we later become aware that it is not likely to be achieved, except as required by law. You are advised, however, to consult any further disclosures we make on related subjects in Ambac’s reports to the Securities and Exchange Commission.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

The discussion and analysis of our financial condition and results of operations are based upon our Consolidated Financial Statements, which have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”). The preparation of these financial statements requires us to make estimates and judgments that affect the reported amount of

1    Ambac Financial Group, Inc. and Subsidiaries

assets and liabilities, revenues and expenses and related disclosure of contingent assets and liabilities at the date of our financial statements. Actual results may differ from these estimates under different assumptions or conditions.

Critical accounting policies and estimates are defined as those that require management to make significant judgments and could potentially result in materially different results under different assumptions and conditions. Management has identified the accounting for loss and loss expenses and the valuation of financial instruments as critical accounting policies. This discussion should be read in conjunction with the consolidated financial statements and notes thereon included elsewhere in this report. Management has discussed each of these critical accounting policies and estimates with the Audit Committee of the Board of Directors.

Financial Guarantee Insurance Losses and Loss Expenses. The loss reserve for financial guarantee insurance discussed in this critical accounting policy and estimates disclosure relates only to the Company’s non-derivative insurance business. Losses and loss expenses are based upon estimates of the ultimate aggregate losses inherent in the non-derivative Financial Guarantee portfolio as of the reporting date. The evaluation process for determining the level of reserves is subject to certain estimates and judgments. Please refer to Note 2 to the Consolidated Financial Statements — “Significant Accounting Policies” for additional detail on loss reserves and potential accounting changes.

The liability for losses and loss expenses consists of active credit and case basis credit reserves. Ambac establishes an active credit reserve to reflect probable and estimable losses due to credit deterioration on insured credits that have not yet defaulted or been reported as of the reporting date. The active credit reserve is established through a process that begins with statistical estimates of probable losses inherent in the adversely classified credit portfolio. Statistical estimates are computed on each adversely classified credit. These statistical estimates are based upon: (i) Ambac’s internal system of credit ratings, which are analogous to the risk ratings of the major rating agencies; (ii) internally developed historical default information (taking into consideration ratings and average life of an obligation); (iii) internally developed loss severities; and (iv) the net par outstanding on the adversely classified credit. The loss severities and default information are based on rating agency information and are specific to each bond type and are established and approved by Ambac’s Portfolio Risk Management Committee. The Portfolio Risk Management Committee is comprised of senior risk management professionals and other senior management of Ambac. For certain credit exposures that have deteriorated significantly, Ambac will undertake additional monitoring and loss remediation efforts. Additional remediation can include various actions by the Company. The most common actions include obtaining detailed appraisal information on collateral, more frequent meetings with the issuer’s or servicer’s management to review operations, financial condition and financial forecasts and more frequent analysis of the issuer’s financial statements. For these credits the Company would use relevant information obtained from its remediation efforts to adjust the statistical estimate discussed above.

Case basis credit reserves are established for losses on insured obligations that have already defaulted. We believe our definition of case basis credit reserves differs from other financial guaranty industry participants. Our case reserves represent the present value of anticipated loss and loss expense payments expected over the estimated period of default. Loss and loss expenses consider defaulted debt service payments, estimated expenses associated with settling the claims and estimated recoveries under collateral and subrogation rights.

The primary estimates impacting the statistical loss calculation are probability of default and severity of loss. The probability of default increases as a credit exposure deteriorates in quality. Political, economic or other unforeseen events could have an adverse impact on default probabilities. However, despite such unforeseen events, our experience has shown, it is not reasonably likely that there would be a change in the probability of default estimates such that a material change in our loss reserve estimate would occur. Our experience has shown that credit deterioration and related changes in default probabilities are a gradual process that typically occurs over a long period of time. Historically, claim payments on financial guarantee contracts have been infrequent but subject to potential high severity. Severity represents the amount of loss that would be incurred on a defaulted obligation due to the difference in the amount of net par guaranteed and the value of the related collateral and other subrogation rights. Loss severity estimates are based upon available information such as rating agency recovery rates or surveillance data such as collateral appraisals. However, severity data used are estimates that are subject to change with political, economic and other market conditions or as new information becomes available. Severity of loss is a primary assumption used to estimate losses and an increase or decrease of the severity would provide a range of reasonably possible future outcomes that would differ from our current loss estimate, which could be material.

Ambac has exposure to various bond types. Our experience has shown that for the majority of bond types, the estimate of loss severity has remained consistent in that material changes to severity estimates have not occurred. However, for certain bond types, factors or events could have a material impact on the estimate of loss severity. Based upon our historical experience, certain types of exposures are more likely to experience changes in loss severity estimates. We believe, based on our experience, there are three bond types in particular where it is reasonably possible that a material change in loss severity estimates could occur. These three bond types are aircraft lease securitizations known as Enhanced Equipment Trust Certificates (“EETC”), health care institutions and mortgage-backed and home equity securitizations. The collateral for a EETC bond is commercial aircraft. Intense competition in the global airline industry continues and has been further impacted by lower cost start up regional carriers. As a result, major airlines have been forced to reduce costs and scale back aircraft purchases. Additionally, competition between the largest aircraft manufacturers has served to reduce overall aircraft pricing. These events have adversely impacted the value of certain aircraft and accordingly impacted the loss severity estimates associated with certain EETC exposures. We have observed that the health care industry is also particularly subject to changes in severity estimates. If there is collateral associated with a health care credit it is generally in the form of a hospital facility. The value of that facility is primarily impacted by the essentiality of that facility to a particular community. For example, hospital facilities that do not

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Management’s Discussion and Analysis of Financial Condition and Results of Operations

have significant competition in a community generally have more stable collateral values than facilities in communities with significant competition. It is also reasonably possible that severity estimates could materially change in the mortgage-backed and home equity securitization sector. Severity estimates in this sector are impacted by residential real estate values. Increases in mortgage interest rates, increased unemployment or personal bankruptcies could have an adverse impact on residential real estate values and mortgage-backed and home equity loss severity estimates. The table below outlines the estimated impact on the December 31, 2004 consolidated loss reserve estimate (both active credit and case basis reserve) given certain changes in the loss severity estimates. The change in the loss severity estimates in the table below represent management’s estimate of reasonably possible changes in severity and are based upon our historical experience.

Bond type (Dollars in millions)	Severity assumption		Increase in loss severity assumption		Increase in reserve estimate
EETC	22	%	12	%	$	26
Health care	59	%	41	%	$	31
Mortgage-backed and home equity	19	%	3	%	$	2

Ambac’s management believes that the reserves for losses and loss expenses are adequate to cover the ultimate net cost of claims, but the reserves, including the probability of default and loss severity assumptions are based on estimates and there can be no assurance that the ultimate liability for losses will not exceed such estimates.

Valuation of Financial Instruments. The fair market values of financial instruments held are determined by using independent market quotes when available and valuation models when market quotes are not available. Ambac’s financial instruments categorized as assets are mainly comprised of investments in fixed income securities and are accounted for in accordance with Statement of Financial Accounting Standards (“SFAS”) 115, “Accounting for Certain Investments in Debt and Equity Securities.” SFAS 115 requires that all debt instruments and certain equity instruments be classified in Ambac’s balance sheet according to their purpose and, depending on that classification, be carried at either cost or fair market value. Ambac classifies investments in fixed income securities as available-for-sale.

The fair values of fixed income investments are based primarily on quoted market prices received from a nationally recognized pricing service or dealer quotes. For those fixed income investments where broker quotes were not available, fair values are based on internal valuation models. Key inputs to the internal valuation models include maturity date, coupon and generic yield curves for industry and credit rating characteristics that closely match those characteristics of the specific investment securities being valued. The valuation results from these models could differ materially from amounts that would actually be realized in the market. The percentage of the investment portfolio that is based upon internal valuation models was 2% and 1% at December 31, 2004 and 2003, respectively.

Ambac has a formal review process for all securities in its investment portfolio, including a review for impairment losses. Documentation of our analyses is required under our policy. Factors considered when assessing impairment include: (i) securities whose fair values have declined by 20% or more below amortized cost; (ii) securities whose market values have declined by 5% or more below amortized cost for a continuous period of at least six months; (iii) recent downgrades by rating agencies; (iv) the financial condition of the issuer; (v) whether scheduled interest payments are past due; and (vi) whether Ambac has the ability and intent to hold the security for a sufficient period of time to allow for anticipated recoveries in fair value. If we believe a decline in the value of a particular investment is temporary, we record the decline as an unrealized loss, net of tax, in Accumulated Other Comprehensive Income in Stockholders’ Equity on our Consolidated Balance Sheets. If we believe the decline is “other than temporary,” we write-down the carrying value of the investment and record a loss on our Consolidated Statements of Operations. Ambac’s assessment of a decline in value includes management’s current judgment of the factors noted above. If that judgment changes in the future, Ambac may ultimately record a loss after having originally concluded that the decline in value was temporary.

Ambac’s exposure to derivative instruments is created through interest rate, currency, total return and credit default swaps. These contracts are accounted for under SFAS 133 “Accounting for Derivative Instruments and Certain Hedging Activities,” as amended (“SFAS 133”). When available, quotes are obtained from independent market sources. However, when quotes are not available, Ambac uses internally developed valuation models. These valuation models require market-driven inputs, including contractual terms, credit spreads on underlying referenced obligations, yield curves and tax-exempt interest ratios. The net fair value of derivative contracts classified as held for trading purposes was $110 million at December 31, 2004. Contracts with maturities in excess of five years accounted for $112 million of the net fair value. Contracts with maturities of five years or less accounted for $(2) million of net fair value. At the inception of a derivative contract (day one), we value the contract at the model value if we can verify all of the significant model inputs to observable market data. Where we cannot verify all of the significant model inputs to observable market data, we value the contract at the transaction price at inception and, consequently, record no gain or loss in accordance with EITF Issue No. 02-3, “Issues Involved in Accounting for Derivative Contracts Held for Trading Purposes and Contracts Involved in Energy Trading and Risk Management Activities.” For additional information regarding the sensitivity of these instruments, see “Risk Management — Market Risk” below.

RESULTS OF OPERATIONS

The following paragraphs describe the consolidated results of operations of Ambac and its subsidiaries for 2004, 2003 and 2002, and its financial condition as of December 31, 2004 and 2003. These results are presented for Ambac’s two reportable segments: Financial Guarantee and Financial Services.

3    Ambac Financial Group, Inc. and Subsidiaries

Income From Continuing Operations. Ambac’s income from continuing operations in 2004 was $725.8 million or $6.54 per diluted share, an increase of $97.7 million, compared to $628.1 million or $5.74 per diluted share in 2003. Ambac’s income before income taxes was $976.8 million in 2004, an increase of 15% from income before income taxes of $849.6 million in 2003. Of the $976.8 million of income (loss) before income taxes in 2004, $987.4 million was from Financial Guarantee, $52.7 million from Financial Services and $(63.3) million from Corporate. Corporate consists primarily of Ambac’s interest expense on the Company’s debentures outstanding. That compares to income (loss) before income taxes in 2003 of $888.1 million, $23.0 million and $(61.5) million from Financial Guarantee, Financial Services and Corporate, respectively. Financial Guarantee income before income taxes increased as a result of (i) higher net premiums earned and other credit enhancement fees, (ii) higher net investment income and (iii) higher net mark-to-market gains on credit derivative contracts, partially offset by (i) a higher provision for losses and loss expenses and (ii) higher operating expenses. Financial Services increase is primarily attributable to (i) higher net interest earned from investment agreements and (ii) higher derivative products revenue.

Included in the 2004 income from continuing operations in the Financial Guarantee segment, is the impact of cancellations of certain reinsurance contracts with two reinsurers, AXA Re Finance S.A. and American Re-Insurance Company, both of which had been downgraded by the rating agencies in 2003. The net impact of these cancellations to the Consolidated Statements of Operations in 2004 amounted to approximately $7.0 million, $4.5 million after-tax, or $0.04 per diluted share.

Ambac’s income from continuing operations in 2003 increased $196.2 million compared to $431.9 million or $3.96 per diluted share, in 2002. Ambac’s income before income taxes in 2003 was up 51% from income before income taxes of $563.3 million in 2002. This increase was attributable to growth in the Financial Guarantee segment and net realized investment losses in 2002 in the Financial Services segment. Income (loss) before income taxes in 2002 consisted of $712.9 million from Financial Guarantee, ($103.7) million from Financial Services and $(45.9) million from Corporate.

Net (Loss) Income From Discontinued Operations. In November 2003, Ambac announced that it had entered into an agreement to sell the operations of Cadre Financial Services, Inc. and Ambac Securities, Inc., its investment advisory and cash management business. The transaction closed during the first quarter of 2004, with proceeds of $3.7 million in cash and $4.7 million in a note. This business had been part of the Financial Services segment.

The net (loss) income from discontinued operations was ($1.3) million, ($9.2) million and $0.7 million for 2004, 2003 and 2002, respectively. The primary reason for the 2004 loss was a purchase price adjustment due to lower than anticipated revenues. The net loss for 2003 included a goodwill write-down of $4.7 million.

Financial Guarantee

Ambac provides financial guarantees for debt obligations through its principal operating subsidiary Ambac Assurance Corporation, as well as credit protection in the form of structured credit derivatives through Ambac Credit Products LLC, a wholly-owned subsidiary of Ambac Assurance. Ambac provides these services in three principal markets: public finance, structured finance and international finance.

Ambac guaranteed $118.1 billion of gross par value bonds during 2004, an increase of 2% from $115.3 billion in 2003. Par value written during 2003 decreased 1% compared to $116.4 billion written during 2002.

The following table provides a breakdown of guaranteed net par outstanding by market sector at December 31, 2004 and December 31, 2003:

(Dollars in billions) December 31,	2004		2003
Public Finance	$	239.7	$	215.3
Structured Finance		132.4		124.1
International Finance		87.3		86.4
Total net par outstanding (1)	$	459.4	$	425.8

⁽¹⁾ $8.5 billion of the net par outstanding increase in 2004 was a result of the reinsurance cancellations noted above.

The following table provides a rating distribution of financial guarantee net par based upon internal Ambac Assurance credit ratings at December 31, 2004 and December 31, 2003:

December 31,	Percentage of Guaranteed Portfolio (1)
	2004	2003
AAA	8	10
AA	23	22
A	47	47
BBB	21	20
Below investment grade	1	1
Total	100	100

⁽¹⁾ Internal Ambac Assurance credit ratings are provided solely to indicate the underlying credit quality of guaranteed obligations based on the view of Ambac and may differ from ratings determined by the independent rating agencies. They are subject to revision at any time and do not constitute investment advice. Ambac Assurance has insured the obligations listed and may also provide other products or services to the issuers of these obligations for which Ambac may have received premiums or fees.

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Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following table provides a distribution by bond type of Ambac Assurance’s below investment grade exposures at December 31, 2004 and 2003. Below investment grade are generally defined as those exposures with a credit rating below BBB–.

Bond Type: (Dollars in millions)	Summary of Below Investment Grade Exposure(1)
	2004		2003
U.S. Public Finance:
Health care	$	571	$	839
Tax-backed		135		139
General obligation		104		42
University		38		40
Other		151		154
Total U.S. Public Finance		999		1,214
U.S. Structured Finance:
Investor-owned utilities		803		875
Mortgage-backed and home equity		774		710
Pooled debt obligations		481		849
Asset-backed		426		68
Total U.S. Structured Finance		2,484		2,502
International Finance:
Pooled debt obligations		510		660
Transportation revenue		215		117
Investor-owned utilities		59		—
Sovereign/sub-sovereign		38		38
Other		223		213
Total International Finance		1,045		1,028
Grand Total	$	4,528	$	4,744

(1) Rating agencies do not publish separate underlying ratings (those ratings excluding Ambac’s guarantee). As such, the ratings disclosed represent Ambac Assurance internal ratings.

The total number of credits with Ambac Assurance ratings below investment grade were 73 and 75 at December 31, 2004 and 2003, respectively. The declines related primarily to health care and pooled debt obligations being upgraded during 2004, partially offset by downgrades of mortgage-backed and asset-backed obligations. U.S. Structured Finance asset-backed below investment grade includes $205 million relating to Ambac Assurance’s exposures to Enhanced Equipment Trust Certificates as discussed further below.

Public Finance. Public finance obligations are bonds issued by states, municipalities and other governmental or not-for-profit entities located in the United States (“Public Finance”). Bond proceeds are used to finance or refinance a broad spectrum of public purpose initiatives, including education, utility, transportation, health care and other general purpose projects. Included in transportation obligations is exposure to U.S. airports of $7.9 billion at December 31, 2004. Airport obligations are generally supported by (i) terminal lease revenues, parking and other concession revenues; (ii) passenger facility charges; or (iii) payments in respect of specific airport facilities. Although Ambac Assurance guarantees the full range of Public Finance obligations, Ambac Assurance concentrates on those projects that require more structuring skills. Certain projects, which had been financed by the local or U.S. government alone, are now being financed through public-private partnerships. In these transactions, debt service on the bonds, rather than being paid solely by tax revenues or other governmental funds, is being paid from a variety of revenue sources, including revenues derived from the project itself. Examples of these transactions include stadium financings, student housing and military housing.

Public Finance bond obligations par value written was $44.6 billion, $43.0 billion and $42.3 billion for 2004, 2003 and 2002, respectively. Ambac Assurance market share, based upon par insured, is up approximately 2% over 2003 and 2002, from approximately 21% in 2002 and 2003 to approximately 23% in 2004. Insured market penetration was 55% in 2004, the highest in the past 10 years, up from 50% and 49% in 2003 and 2002, respectively.

Structured Finance. Structured finance obligations include the securitization of a variety of asset types such as mortgages, home equity loans, student loans and credit card receivables; commercial asset-backed securities; leases; pooled debt obligations; investor-owned utilities; and asset-backed commercial paper conduits originated in the United States (“Structured Finance”). Included within commercial asset-backed securities are exposures to Enhanced Equipment Trust Certificates of $1.8 billion at December 31, 2004. Enhanced Equipment Trust Certificates are secured financings used by the airline industry to finance aircraft. The financings are tranched to create a priority of interests in the aircraft collateral. Pooled debt obligations, including structured credit derivative transactions, involve the securitization of a diverse portfolio of corporate bonds and loan obligations and asset-backed securities (the “Securitized Assets”). Ambac Assurance’s exposure to these Securitized Assets is mitigated through first loss protection. Typically, first loss protection is in the form of over-collateralization (i.e., the principal amount of the Securitized Assets exceeds the principal amount of the structured finance obligations guaranteed by Ambac Assurance), or excess spread (i.e., interest cash flows on the Securitized Assets is in excess of the interest on the debt obligations guaranteed by Ambac Assurance), which allows the transaction to experience defaults among the Securitized Assets before a default is experienced on the structured finance obligations.

Structured Finance obligations par value written was $53.4 billion, $50.2 billion and $48.8 billion in 2004, 2003 and 2002, respectively. The increase in Structured Finance obligations guaranteed for 2004 as compared to 2003 resulted primarily from higher par written in the consumer asset-backed sector of the market (including mortgage-backed securities), partially offset by a decline in pooled debt obligations and commercial asset-backed transactions. The increase in Structured Finance obligations guaranteed in 2003 compared to 2002 resulted from a large structured transaction, partially offset by lower mortgage-backed and investor-owned utilities guarantees.

International Finance. International finance obligations include public purpose infrastructure projects and asset-backed securities originated outside the United States (“International

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Finance”). Ambac Assurance’s emphasis internationally has been on Western Europe and Australia. In the United Kingdom, Ambac Assurance has participated extensively in the Private Finance Initiative whereby the government has been privatizing certain infrastructure finance activities. Ambac Assurance expects demand for our financial guarantees on Private Finance Initiative transactions to increase in Spain, Portugal and Italy. Ambac Assurance also participates in less developed markets through certain structures such as pooled debt obligations or future flow transactions. Future flow transactions essentially securitize future revenue streams derived from operating receivables or the sale of commodities.

International Finance bond obligations par value written was $20.1 billion, $22.1 billion and $25.2 billion for 2004, 2003 and 2002, respectively. International Finance obligations guaranteed during 2004 is lower than 2003 primarily due to decreases in pooled debt obligations and transportation revenue obligations, which were partially offset by higher mortgage-backed and sovereign/sub-sovereign obligations guaranteed. The decrease in International Finance bond obligations guaranteed in 2003 compared to 2002 is primarily due to significantly lower pooled debt obligations, partially offset by higher transportation revenue and mortgage-backed and home equity guarantees.

Gross Premiums Written. Ambac Assurance receives insurance premiums either upfront at policy issuance or on an installment basis over the life of the transaction. The collection method is determined at the time of policy issuance. Gross premiums written in 2004 were $1,047.8 million, a decrease of 8% from $1,143.7 million in 2003. Up-front premiums written in 2004 were $574.6 million, a decrease of 22% from $739.0 million in 2003. This decrease is a result of reduced business activity in all market sectors — Public, Structured and International Finance. Installment premiums written in 2004 were $473.2 million, an increase of 17% from $404.7 million in 2003. The growth in installment premiums is due to the growing book of business in all three market sectors. Gross premiums written in 2003 increased 27% from $904.0 million in 2002. This is a result of increased business activity in all three market sectors. The following table sets forth the amounts of gross premiums written and related gross par written by type:

	2004				2003				2002
(Dollars in millions)	Gross Premiums Written		Gross Par Written		Gross Premiums Written		Gross Par Written		Gross Premiums Written		Gross Par Written
Public Finance:
Up-front	$	513.4	$	43,914	$	576.0	$	41,282	$	460.6	$	39,221
Installment		24.2		696		16.7		1,745		34.4		3,113
Total Public Finance		537.6		44,610		592.7		43,027		495.0		42,334
Structured Finance:
Up-front		20.0		1,669		82.4		5,697		59.4		3,560
Installment		261.7		51,729		238.2		44,505		212.4		45,282
Total Structured Finance		281.7		53,398		320.6		50,202		271.8		48,842
International Finance:
Up-front		41.2		3,180		80.6		3,459		32.6		1,662
Installment		187.3		16,919		149.8		18,652		104.6		23,539
Total International Finance		228.5		20,099		230.4		22,111		137.2		25,201
Total	$	1,047.8	$	118,107	$	1,143.7	$	115,340	$	904.0	$	116,377
Total up-front	$	574.6	$	48,763	$	739.0	$	50,438	$	552.6	$	44,443
Total installment		473.2		69,344		404.7		64,902		351.4		71,934
Total	$	1,047.8	$	118,107	$	1,143.7	$	115,340	$	904.0	$	116,377

Reinsurance. Ambac Assurance’s reinsurance program is principally comprised of a surplus share treaty and facultative reinsurance. The surplus share treaty requires Ambac Assurance to cede covered transactions while retaining flexibility to cede those transactions within a predefined range. Certain types of transactions are excluded from the surplus share treaty and management may use facultative reinsurance to cede such risks. Ceded premiums written in 2004 were $70.9 million, down 49% from $138.1 million in 2003. Ceded premiums as a percentage of gross premiums written were 6.8% and 12.1% for 2004 and 2003, respectively. During the second quarter of 2004, Ambac Assurance completed the cancellation of certain reinsurance contracts with two reinsurers, and included in ceded premiums written for 2004 is $64.8 million in return premiums from the cancellations. Excluding the return premiums, ceded premiums as a percentage of gross premiums written were 13.0% for 2004. Ceded premiums written in 2003 were up 22% from $113.5 million in 2002, which represented ceded premiums as a percentage of gross premiums written of 12.6%.

The reinsurance of risk does not relieve Ambac Assurance of its original liability to its policyholders. In the event that any of Ambac Assurance’s reinsurers are unable to meet their obligations under reinsurance contracts, Ambac Assurance would nonetheless, be liable to its policyholders in the full amount of its

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Management’s Discussion and Analysis of Financial Condition and Results of Operations

policy. To minimize exposure to significant losses from reinsurers, Ambac Assurance (i) monitors the financial condition of its reinsurers; (ii) has collateral provisions in certain reinsurance contracts; and (iii) has certain cancellation rights that can be exercised by Ambac in the event of a rating downgrade of a reinsurer. Ambac Assurance held letters of credit and collateral amounting to approximately $214.5 million from its reinsurers as of December 31, 2004. The rating agencies continually review reinsurers providing coverage to the financial guarantee industry. The following table provides ceded par outstanding by financial strength rating of Ambac’s reinsurers, on a Standard and Poor’s (“S&P”) basis:

(Dollars in billions)	2004		2003
AAA	$	19.7	$	19.3
AA		19.8		15.9
A		2.6		7.7
Not rated		2.1		6.7
Total	$	44.2	$	49.6

As noted above, certain reinsurance contracts with AXA Re Finance S.A. (not rated by S&P) and American Re-Insurance Company (S&P rating of A) were cancelled in 2004 with a reduction of ceded par outstanding of $4.0 billion and $4.5 billion, respectively. Ambac retained the right to cancel the remaining reinsurance contracts with these reinsurers.

In May 2004, Moody’s announced a downgrade of Radian Asset Assurance Inc. from Aa2 to Aa3 (S&P rating of AA). On November 8, 2004, Ambac Assurance notified Radian Asset Assurance (“Radian”) of its intent to cancel, effective February 2005, one reinsurance contract. The exposure ceded under this reinsurance agreement approximated $6.5 billion of par outstanding at December 31, 2004. Based on the exposure at December 31, 2004, the February 2005 recapture will include approximately $54.0 million of written premium to be returned to Ambac Assurance, of which $49.9 million will be deferred. The difference, $4.1 million, which will be recorded in earnings at the time of cancellation, results from the difference between the negotiated amount of returned premiums and the associated unearned premium remaining on the underlying guarantees. Offsetting the earnings are approximately $1.3 million of reinsurance commissions to be paid in excess of the unamortized reinsurance commissions previously deferred. In addition to the $54.0 million of premiums to be collected, approximately $58.5 million in net present value of future installment premiums is expected to be recognized in future earned premiums over the remaining life of the previously reinsured exposures.

Net Premiums Earned and Other Credit Enhancement Fees. Net premiums earned and other credit enhancement fees during 2004 were $764.0 million, an increase of 14% from $667.3 million in 2003. This increase was primarily the result of the larger Financial Guarantee book of business and slightly higher other credit enhancement fees earned from the structured credit derivatives business, partially offset by lower refundings, calls, and other accelerations of previously insured obligations (collectively referred to as “accelerated earnings”) during the year.

When an issue insured by Ambac Assurance has been refunded or called, any remaining unearned premium (net of refunding credits, if any) is earned at that time. The level of refundings or calls vary, depending upon a number of conditions, primarily the relationship between current interest rates and interest rates on outstanding debt. The current relatively low interest rate environment continues to prompt the high levels of refundings. When interest rates further rise in the future, refundings should decline. Earnings on refundings relate to transactions where the premium was paid up-front at the inception of the policy. Accelerated earnings also include the difference between negotiated return premiums and the associated unearned premium on reinsurance cancellations. Net premiums earned included accelerated earnings of $81.9 million and $82.1 million during 2004 and 2003, respectively.

Excluding the effect of accelerated earnings, normal net premiums earned (which is defined as net premiums earned less accelerated earnings and reconciled to total net premiums earned in the table below) in 2004 were $634.8 million, an increase of 18% from $538.2 million in 2003. Normal net premiums earned for the year ended December 31, 2004 increased 18%, 12% and 29% for Public, Structured and International Finance, respectively, from the year ended December 31, 2003.

Overall, the business environment has become more competitive. Increased competition from senior/subordinated structures and other triple-A-rated financial guarantors has increased. This increased competition has had a moderately adverse impact on pricing. Credit spreads and pricing continue to provide adequate returns in most markets. The growth in normal earned premiums in Structured Finance and International Finance that has been exhibited over the past several years has moderated as those lines of business have grown significantly, resulting in more difficult comparisons. Additionally, in the mortgage-backed sector, financial guarantors have faced increased competition from senior/subordinated debt structures and other triple-A-rated financial guarantors. This, combined with the continued high level of run-off in the mortgage-backed securities book, adversely impacted earned premiums. We expect this trend to continue, and therefore, anticipate lower growth rates in normal earned premiums in 2005.

The mortgage-backed securities and pooled debt obligation exposures have relatively short average lives. As a result, the earnings from those types of exposures are recognized quickly. A significant portion of the recent premium writings in Public Finance and for certain bond types within Structured Finance and International are for longer-term transactions. While the earned premium impact from such writings is not as immediate as the mortgage-backed or pooled debt obligations, they do contribute stability to the earned premiums over time. Similarly, due to a tight credit spread environment in International Finance, the pooled debt obligation market has decreased significantly, adversely impacting earned premium growth and other credit enhancement fee growth. Competitive and credit trends such as the ones we are currently experiencing in domestic mortgage-backed securities and international pooled debt obligations are a normal part of Ambac Assurance’s business.

7    Ambac Financial Group, Inc. and Subsidiaries

Other credit enhancement fees in 2004, which is primarily comprised of fees received from the structured credit derivatives product, were $47.3 million, an increase of 1% from $46.9 million in 2003. Credit spreads on corporate credits in the current environment have narrowed and this has had an adverse impact on new credit derivative business in 2004 (when credit spreads are narrow, the demand for guaranteed products is reduced).

Net premiums earned and other credit enhancement fees during 2003 increased 33% from $500.3 million in 2002. This increase was primarily the result of the larger Financial Guarantee book of business, higher accelerated earnings and higher other credit enhancement fees earned from structured credit derivatives. Net premiums earned in 2002 included $52.0 million from accelerated earnings. Excluding the effect of accelerated earnings, normal net premiums earned in 2003 increased 28% from $419.5 million in 2002. Other credit enhancement fees increased 63% from $28.8 million in 2002.

The following table provides a breakdown of net premiums earned by market sector and other credit enhancement fees:

(Dollars in millions)	2004		2003		2002
Public Finance	$	207.4	$	176.5	$	149.3
Structured Finance		263.7		234.8		181.7
International Finance		163.7		126.9		88.5
Total normal premiums earned		634.8		538.2		419.5
Accelerated earnings		81.9		82.2		52.0
Total net premiums earned		716.7		620.4		471.5
Other credit enhancement fees		47.3		46.9		28.8
Total net premiums earned and other credit enhancement fees	$	764.0	$	667.3	$	500.3

Net Investment Income. Net investment income in 2004 was $361.1 million, an increase of 12% from $321.1 million in 2003. The increase was attributable to: (i) the growth of the investment portfolio resulting from the growth in premiums generated by the Financial Guarantee book of business; and (ii) capital contributions from Ambac Financial Group, Inc. to Ambac Assurance totaling approximately $125 million during the fourth quarter of 2003, $20 million in the third quarter of 2004 and $43 million in the fourth quarter of 2004. This increase was partially offset by a lower reinvestment rate due to the interest rate environment. Investments in tax-exempt securities amounted to 68% of the total fair value of the portfolio as of December 31, 2004, versus 71% as of December 31, 2003 and 2002. The average pre-tax yield-to-maturity on the investment portfolio was 4.55% as of December 31, 2004 compared to 4.93% and 5.18% at December 31, 2003 and 2002, respectively. Net investment income in 2003 increased 8% from $297.3 million in 2002. This increase was primarily attributable to the growth of the investment portfolio resulting from the growth in the Financial Guarantee book of business and a capital contribution from Ambac Financial Group, Inc. to Ambac Assurance totaling approximately $75 million during the first quarter of 2003, partially offset by a lower reinvestment rate due to the interest rate environment.

Net Realized Investment Gains. Net realized investment gains in 2004 were $30.0 million, compared to net realized gains of $40.2 million and $40.9 million in 2003 and 2002, respectively. The following table details amounts included in net realized gains:

(Dollars in millions)	2004		2003		2002
Net gains on securities sold	$	24.3	$	31.7	$	39.1
Net foreign exchange gains on investments		5.7		8.5		1.8
Net realized gains	$	30.0	$	40.2	$	40.9

Net gains on securities sold are generated as a result of the ongoing management of the investment portfolio. Foreign exchange gains and losses primarily resulted from sales of long-term foreign currency denominated securities in 2004 and 2003 and investments in short-term foreign currency denominated securities in 2002.

Net Mark-to-Market Gains (Losses) on Credit Derivative Contracts. Net mark-to-market gains on credit derivative contracts in 2004 were $17.7 million, compared to net mark-to-market gains (losses) of $0.0 million and $(27.9) million in 2003 and 2002, respectively. The change in estimated fair value of structured credit derivative contracts reflects net mark-to-market gains and losses due to changes in credit spreads on the underlying obligations. Realized net losses paid on structured credit derivatives totaled none, $1.2 million and $5.8 million for the years ended December 31, 2004, 2003 and 2002, respectively.

Other (Loss) Income. Other (loss) income in 2004 was ($4.1) million, as compared to $5.0 million in 2003. Included in other income are deal structuring fees, commitment fees and income from Ambac’s Qualifying Special Purpose Entities (“QSPEs”). On a limited basis, Ambac provides clients the ability to fund through a medium-term note (“MTN”) conduit vehicle. This conduit issues MTNs and purchases client issued fixed income securities with the proceeds. An equity loss of approximately $13 million was recorded during 2004 from this funding conduit. The loss primarily relates to a mark-to-market on certain derivative contracts used to hedge interest rate risk associated with underlying investments and MTN liabilities. The derivatives serve as effective economic hedges; however, they did not meet the requirements of effective accounting hedges as defined in SFAS No. 133. Therefore, the change in the market value of the derivatives was recorded through the income statement without taking the offsetting gain from the hedged instruments. Other income decreased 9% in 2003 from $5.5 million in 2002.

Losses and Loss Expenses. Losses and loss expenses in 2004 were $69.6 million, versus $53.4 million in 2003 and $26.7 million in 2002. This increase reflects downward credit migration on certain exposures in the financial guarantee portfolio. Losses and loss expenses are based upon estimates of the aggregate losses inherent in the Financial Guarantee portfolio as of the reporting date. Please refer to the “Critical Accounting Policies and Estimates” section of this Management’s Discussion and Analysis and to Note 2 of the Consolidated Financial Statements for further background information on loss reserves, our policy and for further explanation of potential changes.

Ambac Financial Group, Inc. and Subsidiaries    8

Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following tables provide details of losses paid, net of recoveries received for the years ended December 31, 2004, 2003 and 2002 and gross case reserves at December 31, 2004 and December 31, 2003:

(Dollars in millions)	2004			2003		2002
Net losses paid (recovered):
Public Finance	$	19.9		$	5.8	$	6.0
Structured Finance		(5.0	)		26.9		3.2
International Finance		4.0			1.4		—
Total	$	18.9		$	34.1	$	9.2

(Dollars in millions)	2004		2003
Gross case basis credit reserves:
Public Finance	$	47.0	$	23.3
Structured Finance		80.0		28.5
International Finance		6.3		5.4
Total	$	133.3	$	57.2

The following table summarizes Ambac’s loss reserves split between case basis credit loss reserves and active credit reserves at December 31, 2004 and 2003:

(Dollars in millions)	2004		2003
Gross loss and loss expense reserves:
Case basis credit reserves	$	133.3	$	57.2
Active credit reserves		120.8		132.2
Total	$	254.1	$	189.4

The 2004 provision for losses was primarily impacted by two credits. The first credit is a domestic health care institution, which defaulted in a prior year and continues to experience significant financial stress. Ambac’s gross exposure to this credit amounts to approximately $73 million at December 31, 2004. There is no reinsurance for this exposure. At December 31, 2004, $40 million of case basis credit reserves were held for this health care exposure. During 2004, $25 million of additional provision for losses was recorded for this transaction based on our analysis of deteriorating financial information. Ambac is closely surveilling the credit and is in frequent communication with management. Ambac believes the primary factor causing the loss on this exposure is the competitive local environment for health care delivery and the resulting impact on revenue generation. The second credit is an enhanced equipment trust certificate (“EETC”) securitization. This transaction is secured by seven commercial aircraft, including the lease income generated by leases of the aircraft to a commercial airline. During 2004, the airline leasing the aircraft filed for bankruptcy and defaulted on its lease obligations. Ambac insured the most senior debt layer of the transaction and has gross exposure to this transaction of approximately $174 million. The exposure, net of reinsurance, is approximately $127 million. At December 31, 2004, approximately $55 million of gross case basis credit reserves were held for this EETC exposure ($40 million, net of reinsurance). Provision for losses of $40 million was recorded during 2004 to reflect the deterioration of this exposure. A reduction of any of the outstanding exposure is entirely dependent upon the value of the aircraft collateral underlying the transaction. Ambac is entitled to direct that the aircraft be sold outright or leased and the related proceeds would be used to reduce the exposure outstanding. Aircraft valuations have declined sharply over recent years. Management believes the primary factor that has adversely impacted collateral values is the severely distressed financial condition of the airline industry. The airline industry has been adversely impacted by several factors including the September 11 terrorist attacks on the United States and the related adverse impact it had on passenger demand. Other important factors adversely impacting the airline industry include high fuel costs and intense price competition. Additional deterioration in these or other factors could have a further adverse impact on the aircraft collateral values, which would require additional loss reserves.

At December 31, 2004, estimated future claim payments, net of estimated recoveries totaled $155.9 million. Related future payments are $93.8 million, $8.8 million, $3.3 million, $4.7 million and $8.5 million for 2005, 2006, 2007, 2008 and 2009, respectively. Additions made to the case basis credit reserve totaled $76.0 million, $3.6 million and $28.9 million in 2004, 2003 and 2002, respectively. The increase in the 2004 case basis credit reserve was primarily due to $35.2 million of previously anticipated recoveries received and an increase of approximately $95.0 million in reserves for a health care credit and an EETC credit discussed above, offset by $55.3 million in claim payments.

Underwriting and Operating Expenses. Underwriting and operating expenses of $106.6 million in 2004 increased by 16% from $92.0 million in 2003. Underwriting and operating expenses in 2003 increased 20% from $76.5 million in 2002. Underwriting and operating expenses consist of gross underwriting and operating expenses, less the deferral to future periods of expenses and reinsurance commissions related to the acquisition of new insurance contracts, plus the amortization of previously deferred expenses and net reinsurance commissions. The following table provides details of underwriting and operating expenses for the 2004, 2003 and 2002:

(Dollars in millions)										% Change
	2004			2003			2002			2004 vs. 2003		2003 vs. 2002
Gross underwriting and operating expenses	$	144.8		$	135.8		$	117.7		7	%	15	%
Net reinsurance commissions received (1)		(15.9	)		(40.1	)		(30.7	)
Operating expenses and reinsurance commissions deferred		(47.6	)		(42.2	)		(42.8	)
Amortization of previously deferred expenses (1)		25.3			38.5			32.3
Underwriting and operating expenses	$	106.6		$	92.0		$	76.5		16	%	20	%

⁽¹⁾ The 2004 cancellation of reinsurance contracts disclosed above impacted net reinsurance commissions received and the amortization of previously deferred expenses by $(19.8) million and $16.3 million, respectively.

9    Ambac Financial Group, Inc. and Subsidiaries

The increases in gross underwriting and operating expenses in 2004 and 2003 reflect the overall increased business activity in those years and are primarily attributable to higher compensation costs related to the addition of staff, including the expensing of stock options that began in 2003. Stock-based compensation expenses in 2004, 2003 and 2002 were $21.9 million, $14.3 million and $2.7 million, respectively.

Financial Services

Through its Financial Services subsidiaries, Ambac provides financial and investment products including investment agreements, interest rate swaps, total return swaps and funding conduits, principally to clients of the financial guarantee business, which includes municipalities and other public entities, health care organizations, and asset-backed and structured finance issuers.

Revenues in 2004 increased 2% to $236.3 million from $231.4 million in 2003. This increase is primarily due to higher derivative products revenue of $35.8 million in 2004, up 74% from $20.6 million in 2003 due to increased swap activity and net positive mark-to-market adjustments in 2004 compared to net negative mark-to-market adjustments recorded in 2003. Partially offsetting this increase was lower interest earned from investment and payment agreements which was $198.8 million down 6% from $212.0 million in 2003. The decline in earned interest from investment and payment agreements is primarily due to a decrease in the overall size of the investment portfolio related to the investment agreement business.

Revenues in 2003 increased 68% from $137.4 million in 2002. This increase in revenue was primarily due to net realized investment losses of $134.1 million in 2002 compared to net realized investment losses $2.0 million in 2003 and an increase in derivative product revenues of 18% from $17.4 million in 2002. Partially offsetting this was a decline in investment and payment agreements of 17% from $255.0 million. The investment agreement business had been adversely impacted by the decline in interest rates. The decline in interest rates resulted in lower income on cash held for liquidity purposes. Additionally, certain mortgage-backed investments prepaid, causing the related proceeds to be reinvested at lower yields.

The 2003 and 2002 realized investment loss resulted primarily from a write-down of asset-backed notes issued by National Century Financial Enterprises, Inc. (“NCFE”). These notes, which were rated triple-A until October 25, 2002, defaulted and NCFE filed for protection under Chapter 11 of the U.S. Bankruptcy Code in November 2002. The NCFE notes, which are backed by health care receivables were initially written down by $139.7 million to 20% of par value at December 31, 2002. The NCFE notes were further written down by $10.5 million in 2003 to approximately 14% of par value at December 31, 2003. As of December 31, 2004, NCFE is valued at 4% of par value due to cash received from the distribution of assets in the trust by the bankruptcy trustee. This value represents Ambac’s best estimate of its recovery from assets in the trust based on existing facts and circumstances and presumes no recovery from litigation. This loss was specific to the NCFE notes and had no impact on other investments held.

Financial Services expenses were $183.6 million, $208.4 million and $241.2 million for 2004, 2003 and 2002, respectively. Included in the above are expenses related to investment and payment agreements of $168.9 million, $196.3 million and $231.3 million for 2004, 2003 and 2002, respectively. These declines are primarily related to decreases in the average volume of investment agreements outstanding and were impacted by lower rates on floating rate investment agreements. Other expenses of $14.7 million, $12.1 million and $9.9 million are higher primarily due to higher compensation expenses.

Corporate Items

Interest Expense. Interest expense was $54.3 million, $54.2 million and $43.7 million in 2004, 2003 and 2002, respectively. The increase in 2003 compared to 2002 is primarily attributable to Ambac’s issuance of $200 million, 5.95% debt, due February 28, 2103, issued in February 2003 and the issuance of $175 million, 5.875%, due March 24, 2103, issued in March 2003. This was partially offset by the redemption at par of Ambac’s $200 million, 7.08% debentures in April 2003. For additional information, please refer to “Liquidity and Capital Resources — Ambac Financial Group, Inc. Liquidity” section.

Corporate Expenses. Corporate expenses include the operating expenses of Ambac Financial Group. Corporate expenses were $10.7 million, $14.6 million, and $7.2 million in 2004, 2003 and 2002, respectively. The decrease in expenses in 2004 is primarily attributable to a $6.5 million write-off of previously deferred debt issuance expenses in the first quarter of 2003 related to the 1998 issuance of $200 million, 7.08% Debentures, that was redeemed at par at the end of April 2003, partially offset by costs in 2004 relating to the compliance with the Sarbanes-Oxley Act of 2002.

Provision for Income Taxes. Income taxes for continuing operations for 2004 were at an effective rate of 25.7%, compared to 26.1% and 23.3% for 2003 and 2002, respectively. The decrease in the effective tax rate in 2004 as compared to 2003 is due to the release of tax reserves of $8.2 million related to the expiration of the statute of limitations of an earlier tax year partially offset by an increase in underwriting profits. The increase in the effective tax rate in 2003 as compared to 2002 is primarily due to increased underwriting profits in 2003 and the NCFE loss and the related reduction in taxable profits in 2002.

LIQUIDITY AND CAPITAL RESOURCES

Ambac Financial Group, Inc. Liquidity. Ambac’s liquidity, both on a short-term basis (for the next twelve months) and a long-term basis (beyond the next twelve months), is largely dependent upon: (i) Ambac Assurance’s ability to pay dividends or make other payments to Ambac; (ii) external financings and (iii) investment income from its investment portfolio. Pursuant to Wisconsin insurance laws, Ambac Assurance may declare dividends, provided that, after giving effect to the distribution, it would not violate certain statutory equity, solvency and asset tests. Based upon these tests, without regulatory approval, the maximum amount that will be available during 2005 for payment of dividends by Ambac Assurance is approximately $320.0 million. During 2004, Ambac Assurance and Ambac Capital Corporation paid dividends of $103.0 million and $5.1 million, respectively, on their common stock to Ambac.

Ambac Financial Group, Inc. and Subsidiaries    10

Management’s Discussion and Analysis of Financial Condition and Results of Operations

Ambac’s principal uses of liquidity are for the payment of its operating expenses, income taxes, interest on its debt, dividends on its shares of common stock, purchases of its common stock in the open market and capital investments in its subsidiaries. Ambac contributed $62.6 million in the form of cash and fixed income securities to Ambac Assurance Corporation during 2004.

The following table includes aggregated information about contractual obligations for Ambac, excluding those of entities consolidated under the provisions of the Financial Accounting Standards Board (“FASB”) Interpretation No. 46, “Consolidation of Variable Interest Entities” (“FIN 46”). For a further discussion of FIN 46, see “Special Purpose and Variable Interest Entities” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations. These contractual obligations impact Ambac’s short-and long-term liquidity and capital resource needs. The table includes information about payments due under specified contractual obligations, aggregated by type of contractual obligation, including claim payments, the maturity profile of Ambac’s consolidated long-term debt obligations, investment agreement obligations, payment agreement obligations and operating leases.

	Contractual Obligations by Year
(Dollars in millions)	2005		2006		2007		2008		2009		Thereafter
Long-term debt obligations (1)	$	—	$	—	$	—	$	—	$	—	$	791.8
Investment agreement obligations		1,142.0		507.8		1,006.2		834.2		277.6		2,290.4
Payment agreement obligations		17.2		21.6		23.4		31.4		21.7		782.4
Operating lease obligations		8.0		7.9		7.6		7.9		8.2		84.1
Purchase obligations (2)		7.1		2.3		2.3		1.4		—		—
Pension and post retirement benefits (3)		2.5		3.2		3.4		3.6		3.8		23.5
Other long-term liabilities (4)		93.8		8.8		3.3		4.7		8.5		36.8
Total	$	1,270.6	$	551.6	$	1,046.2	$	883.2	$	319.8	$	4,009.0

⁽¹⁾ For additional information about long-term debt, see Note 7 to the Consolidated Financial Statements.

⁽²⁾ Purchase obligations includes various technology related maintenance agreements, rating agency fees and other outside services.

⁽³⁾ Amount represents expected contributions to the funded defined benefit pension plan and benefit payments on unfunded pension and other postretirement benefit plans for the next 10 years. Contributions to the funded pension plan are equal to the maximum amount that can be deducted for Federal income tax purposes, under current law.

⁽⁴⁾ Amount represents expected claim payments on financial guarantee insurance contracts that have already defaulted. Expected claim payments on financial guarantee insurance contracts that have not yet defaulted are not included.

A subsidiary of Ambac Financial Group provides a $360 million liquidity facility to a reinsurance company which acts as reinsurer with respect to a portfolio of life insurance policies. The liquidity facility provides temporary funding in the event that the reinsurance company’s capital is insufficient to make payments under the reinsurance agreement. The reinsurance company is required to repay all amounts drawn under the liquidity facility. No amounts have been drawn under this facility at December 31, 2004.

Based on the amount of dividends that it expects to receive from Ambac Assurance and other subsidiaries during 2005, and the income it expects to receive from its investment portfolio, management believes that Ambac will have sufficient liquidity to satisfy its needs over the next twelve months, including the ability to pay dividends on its common stock in accordance with its dividend policy. Beyond the next twelve months, Ambac Assurance’s ability to declare and pay dividends to Ambac may be influenced by a variety of factors including adverse market changes, insurance regulatory changes and changes in general economic conditions. Consequently, although management believes that Ambac will continue to have sufficient liquidity to meet its debt service and other obligations over the long term, no guarantee can be given that Ambac Assurance will be able to dividend amounts sufficient to pay all of Ambac’s operating expenses, debt service obligations and dividends on its common stock.

Ambac Assurance Liquidity. The principal uses of Ambac Assurance’s liquidity are the payment of operating expenses, claim payments, reinsurance premiums, taxes, dividends to Ambac, and capital investments in its subsidiaries. Management believes that Ambac Assurance’s operating liquidity needs can be funded exclusively from its operating cash flow. The principal sources of Ambac Assurance’s liquidity are gross premiums written, scheduled investment maturities, net investment income and receipts from structured credit derivatives.

Financial Services Liquidity. The principal uses of liquidity by Financial Services subsidiaries are payment of investment and payment agreement obligations pursuant to defined terms, net obligations under interest rate and total return swaps, operating expenses and income taxes. Management believes that its Financial Services liquidity needs can be funded primarily from its operating cash flow, the maturity of its invested assets and from time to time, by short-term intercompany loans from Ambac Assurance. The principal sources of this segment’s liquidity are proceeds from issuance of investment agreements, net investment income, maturities of securities from its investment portfolio (which are invested with the objective of matching the maturity schedule of its obligations under the investment agreements) and net receipts from interest rate and total return swaps. The investment objectives with respect to investment

11    Ambac Financial Group, Inc. and Subsidiaries

agreements are to achieve the highest after-tax total return, subject to a minimum average quality rating of Aa/AA on invested assets, and to maintain cash flow matching of invested assets to funded liabilities to minimize interest rate and liquidity exposure. Financial Services subsidiaries maintain a portion of their assets in short-term investments and repurchase agreements in order to meet unexpected liquidity needs.

Credit Facilities. Ambac and Ambac Assurance have a revolving credit facility with six major international banks for $300 million, which expires in July 2005 and provides a two-year term loan provision. The facility is available for general corporate purposes, including the payment of claims. As of December 31, 2004, no amounts were outstanding under this credit facility. This facility’s financial covenants require that Ambac: (i) maintain as of the end of each fiscal quarter a debt-to-capital ratio of not more than 30% and (ii) maintain at all times total stockholders’ equity equal to or greater than $2.0 billion. At December 31, 2004, Ambac met all of these requirements. Prior to July 2004, Ambac and Ambac Assurance had a revolving credit facility with eight major international banks for $300 million. During 2004 and 2003, Ambac paid $0.5 million per year for these credit facilities.

Capital Support. Ambac Assurance has a series of perpetual put options on its own preferred stock. The counterparty to these put options are trusts established by a major investment bank. The trusts were created as a vehicle for providing capital support to Ambac Assurance by allowing it to obtain immediate access to new capital at its sole discretion at any time through the exercise of the put option. If the put option were exercised, Ambac Assurance would receive up to $800 million in return for the issuance of its own perpetual preferred stock, the proceeds of which may be used for any purpose, including the payment of claims. The preferred stock would give investors the rights of an equity investor in Ambac Assurance. Such rights are subordinate to insurance claims, as well as to the general unsecured creditors of Ambac Assurance. Dividend payments on the preferred stock are cumulative only if Ambac Assurance pays dividends on its common stock. Each trust is restricted to holding high-quality short-term commercial paper investments to ensure that it can meet its obligations under the put option. To fund these investments, each trust has issued its own auction market perpetual securities. Each trust is rated AA/Aa2 by Standard & Poor’s and Moody’s, respectively. During 2004 and 2003, Ambac Assurance paid put option fees of $4.7 million per year, which is recorded in adjusted paid-in capital on the Consolidated Financial Statements.

From time to time, Ambac accesses the capital markets to support the growth of its businesses. In April 2003, Ambac filed a registration statement on Form S-3 with the SEC utilizing a “shelf” registration process. Under this process, Ambac may issue up to $500 million of the securities described in the prospectus filed as part of the registration, namely, common stock, preferred stock and debt securities of Ambac.

Shares Repurchased. The Board of Directors of Ambac has authorized the establishment of a stock repurchase program that permits the repurchase of up to 12,000,000 shares of Ambac’s Common Stock. The following table summarizes Ambac’s repurchase program during 2004:

(In thousands, except average per share amounts)	Total Shares Repurchased	Average Price Per Share		Shares Remaining for Repurchase
January 2004	—	$	—	3,717
February 2004	20	$	74.09	3,697
March 2004	298	$	78.90	3,399
First quarter 2004	318	$	78.60	3,399
April 2004	339	$	73.19	3,060
May 2004	27	$	64.61	3,033
June 2004	—	$	—	3,033
Second quarter 2004	366	$	72.55	3,033
July 2004	—	$	—	3,033
August 2004	—	$	—	3,033
September 2004	—	$	—	3,033
Third quarter 2004	—	$	—	3,033
October 2004	2	$	74.81	3,031
November 2004	1	$	79.27	3,030
December 2004	—	$	—	3,030
Fourth quarter 2004	3	$	75.68	3,030

Balance Sheet. Total assets as of December 31, 2004 were $18.59 billion, an increase of 11% from total assets of $16.75 billion at December 31, 2003. This increase was due primarily to cash generated from business written during 2004 and from the consolidation of variable interest entities. Stockholders’ equity as of December 31, 2004 was $5.02 billion, an increase of 18% from $4.25 billion at year-end 2003. The increase stemmed primarily from net income generated for the year.

Ambac Assurance’s investment objectives for the Financial Guarantee portfolio are to maintain an investment duration that closely approximates the expected duration of related financial guarantee liabilities and achieve the highest after-tax net investment income, while maintaining a conservative credit risk profile. The Financial Guarantee investment portfolio is subject to internal investment guidelines, which are approved by Ambac’s Board of Directors. Such guidelines set forth minimum credit rating requirements and credit risk concentration limits.

The Financial Services investment portfolio consists primarily of assets funded with proceeds from the issuance of investment agreement liabilities. The investment objectives of the portfolio are to match, as closely as possible, the duration and maturity schedule of investment securities to the duration and maturity schedule of related liabilities under the investment agreements and achieve the highest after-tax net investment income. The investment portfolio is subject to internal investment guidelines, which are approved by Ambac’s Board of Directors. Such guidelines set forth minimum credit rating requirements and credit risk concentration limits.

Ambac Financial Group, Inc. and Subsidiaries    12

Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following table summarizes the composition of the fair value of Ambac’s investment portfolio by segment at December 31, 2004 and 2003:

(Dollars in millions)	Financial Guarantee			Financial Services			Corporate			Total
2004:
Fixed income securities:
Municipal obligations	$	5,905.0		$	447.2		$	—		$	6,352.2
Corporate obligations		132.4			541.4			—			673.8
Foreign obligations		237.9			—			—			237.9
U.S. government obligations		106.8			18.6			—			125.4
U.S. agency obligations		412.9			463.3			—			876.2
Mortgage and asset-backed securities		1,385.3			4,250.5			—			5,635.8
Other		3.4			—			0.8			4.2
		8,183.7			5,721.0			0.8			13,905.5
Short-term		480.2			4.0			37.0			521.2
		8,663.9			5,725.0			37.8			14,426.7
Fixed income securities pledged as collateral:
Mortgage and asset-backed securities		—			341.7			—			341.7
Total investments		8,663.9		$	6,066.7		$	37.8		$	14,768.4
Percent total		58.7	%		41.1	%		0.2	%		100	%
2003:
Fixed income securities:
Municipal obligations	$	5,305.3		$	428.7		$	—		$	5,734.0
Corporate obligations		465.0			621.2			—			1,086.2
Foreign obligations		177.2			—			—			177.2
U.S. government obligations		83.8			6.2			—			90.0
U.S. agency obligations		215.2			432.5			—			647.7
Mortgage and asset-backed securities		1,066.1			4,230.8			17.2			5,314.1
Other		3.3			—			1.1			4.4
		7,315.9			5,719.4			18.3			13,053.6
Short-term		208.1			6.0			36.3			250.4
		7,524.0			5,725.4			54.6			13,304.0
Fixed income securities pledged as collateral:
U.S. government obligations		—			12.3			—			12.3
Mortgage and asset-backed securities		—			649.1			—			649.1
		—			661.4			—			661.4
Total investments	$	7,524.0		$	6,386.8		$	54.6		$	13,965.4
Percent total		53.9	%		45.7	%		0.4	%		100	%
The following table represents mortgage-backed securities guaranteed by either a U.S. government agency or U.S. government sponsored enterprise at December 31, 2004 and 2003 by segment:
(Dollars in millions)	Financial Guarantee			Financial Services			Corporate			Total
2004:
Government National Mortgage Association	$	36.9		$	13.2		$	—		$	50.1
Federal National Mortgage Association		724.2			508.8			—			1,233.0
Federal Home Loan Mortgage Corporation		271.3			415.7			—			687.0
Vendee Mortgage Trust		—			10.7			—			10.7
Total	$	1,032.4		$	948.4		$	—		$	1,980.8
2003:
Government National Mortgage Association	$	68.4		$	42.0		$	—		$	110.4
Federal National Mortgage Association		603.5			881.7			—			1,485.2
Federal Home Loan Mortgage Corporation		177.8			596.9			—			774.7
Vendee Mortgage Trust		—			11.1			—			11.1
Total	$	849.7		$	1,531.7		$	—		$	2,381.4

13    Ambac Financial Group, Inc. and Subsidiaries

The following table summarizes the total pre-tax gross unrealized losses at December 31, 2004 and 2003 by investment category:

(Dollars in millions)	2004 Gross Unrealized Losses		2003 Gross Unrealized Losses
Fixed income securities:
Municipal obligations	$	7.4	$	6.4
Corporate obligations		3.8		6.4
Foreign obligations		0.4		0.7
U.S. government obligations		0.1		0.4
U.S. agency obligations		4.3		5.1
Mortgage and asset-backed securities		15.4		16.9
Other		0.3		0.4
Total	$	31.7	$	36.3

The following table summarizes, for all securities in an unrealized loss position as of December 31, 2004 and 2003, the aggregate fair value and gross unrealized loss by length of time those securities have been continuously in an unrealized loss position:

	2004				2003
(Dollars in millions)	Estimated Fair Value		Gross Unrealized Losses		Estimated Fair Value		Gross Unrealized Losses
Municipal obligations in continuous unrealized loss for:
0 – 6 months	$	114.2	$	0.7	$	208.8	$	1.2
7 – 12 months		295.4		3.9		225.1		4.8
Greater than 12 months		124.6		2.8		6.5		0.4
		534.2		7.4		440.4		6.4
Corporate obligations in continuous unrealized loss for:
0 – 6 months		54.3		0.3		100.6		1.8
7 – 12 months		3.8		0.3		—		—
Greater than 12 months		33.8		3.2		100.8		4.6
		91.9		3.8		201.4		6.4
Foreign government obligations in continuous unrealized loss for:
0 – 6 months		—		—		36.6		0.7
7 – 12 months		8.5		—		—		—
Greater than 12 months		57.0		0.4		—		—
		65.5		0.4		36.6		0.7
U.S. government obligations in continuous unrealized loss for:
0 – 6 months		14.1		—		50.2		0.4
7 – 12 months		10.6		0.1		—		—
Greater than 12 months		—		—		—		—
		24.7		0.1		50.2		0.4
U.S. agency obligations in continuous unrealized loss for:
0 – 6 months		140.3		0.9		279.0		2.9
7 – 12 months		121.1		1.8		29.4		2.2
Greater than 12 months		29.9		1.6		—		—
		291.3		4.3		308.4		5.1
Mortgage and asset-backed securities in continuous unrealized loss for:
0 – 6 months		585.3		2.5		690.6		7.8
7 – 12 months		455.2		4.5		586.8		7.4
Greater than 12 months		613.7		8.4		166.0		1.7
		1,654.2		15.4		1,443.4		16.9
Other in continuous unrealized loss for:
0 – 6 months		0.1		—		—		—
7 – 12 months		—		—		0.2		—
Greater than 12 months		0.9		0.3		1.5		0.4
		1.0		0.3		1.7		0.4
Total	$	2,662.8	$	31.7	$	2,482.1	$	36.3

Ambac Financial Group, Inc. and Subsidiaries    14

Management’s Discussion and Analysis of Financial Condition and Results of Operations

There were no individual securities with material unrealized losses as of December 31, 2004 and 2003. As of December 31, 2004 below investment grade securities and non-rated securities which were in an unrealized loss position had a fair value of $1.0 million and unrealized loss of $0.3 million, which represented 0.04% of the total fair value and 0.9% of total pre-tax unrealized losses shown in the above table. As of December 31, 2003 below investment grade securities and non-rated securities which were in an unrealized loss position had a fair value of $9.5 million and an unrealized loss of $0.8 million, which represented 0.4% of the total fair value and 2.2% of total pre-tax unrealized losses as shown in the above table.

The following table summarizes amortized cost and fair value for all securities in an unrealized loss position as of December 31, 2004 and 2003, by contractual maturity date:

	2004				2003
(Dollars in millions)	Amortized Cost		Estimated Fair Value		Amortized Cost		Estimated Fair Value
Municipal obligations:
Due in one year or less	$	—	$	—	$	—	$	—
Due after one year through five years		7.8		7.6		—		—
Due after five years through ten years		202.2		199.6		38.8		38.3
Due after ten years		331.6		327.0		408.0		402.1
		541.6		534.2		446.8		440.4
Corporate obligations:
Due in one year or less		—		—		—		—
Due after one year through five years		—		—		12.6		11.9
Due after five years through ten years		50.0		49.8		—		—
Due after ten years		45.7		42.1		195.2		189.5
		95.7		91.9		207.8		201.4
Foreign government obligations:
Due in one year or less		8.5		8.5		—		—
Due after one year through five years		57.4		57.0		19.5		19.2
Due after five years through ten years		—		—		17.8		17.4
Due after ten years		—		—		—		—
		65.9		65.5		37.3		36.6
U.S. government obligations:
Due in one year or less		7.3		7.3		—		—
Due after one year through five years		17.5		17.4		—		—
Due after five years through ten years		—		—		25.6		25.6
Due after ten years		—		—		25.0		24.6
		24.8		24.7		50.6		50.2
U.S. agency obligations:
Due in one year or less		—		—		—		—
Due after one year through five years		215.4		213.0		195.8		195.1
Due after five years through ten years		80.2		78.3		31.7		29.4
Due after ten years		—		—		86.0		83.9
		295.6		291.3		313.5		308.4
Mortgage and asset-backed securities		1,669.6		1,654.2		1,460.3		1,443.4
Other:
Due in one year or less		1.3		1.0		2.1		1.7
Due after one year through five years		—		—		—		—
Due after five years through ten years		—		—		—		—
Due after ten years		—		—		—		—
		1.3		1.0		2.1		1.7
Total	$	2,694.5	$	2,662.8	$	2,518.4	$	2,482.1

15    Ambac Financial Group, Inc. and Subsidiaries

The following table summarizes, for all securities sold at a loss during 2004 and 2003, the aggregate fair value and realized loss by length of time those securities were continuously in an unrealized loss position prior to the sale date:

	2004				2003
(Dollars in millions)	Fair Value		Gross Unrealized Losses		Fair Value		Gross Unrealized Losses
Municipal obligations in continuous unrealized loss for:
0 – 6 months	$	8.3	$	0.1	$	12.8	$	0.1
7 – 12 months		—		—		—		—
Greater than 12 months		2.1		0.1		0.5		—
		10.4		0.2		13.3		0.1
Corporate obligations in continuous unrealized loss for:
0 – 6 months		128.0		8.5		87.4		3.2
7 – 12 months		—		—		2.3		0.5
Greater than 12 months		13.6		1.6		18.4		1.5
		141.6		10.1		108.1		5.2
U.S. government obligations in continuous unrealized loss for:
0 – 6 months		31.8		0.4		145.3		4.1
7 – 12 months		—		—		—		—
Greater than 12 months		—		—		—		—
		31.8		0.4		145.3		4.1
U.S. agency obligations in continuous unrealized loss for:
0 – 6 months		131.9		6.0		72.6		0.7
7 – 12 months		—		—		—		—
Greater than 12 months		—		—		—		—
		131.9		6.0		72.6		0.7
Mortgage and asset-backed securities in continuous unrealized loss for:
0 – 6 months		206.6		1.4		666.7		5.0
7 – 12 months		62.2		0.5		25.5		0.5
Greater than 12 months		32.9		1.5		—		—
		301.7		3.4		692.2		5.5
Other securities in continuous unrealized loss for:
0 – 6 months		36.1		0.8		25.0		0.4
7 – 12 months		—		—		—		—
Greater than 12 months		—		—		—		—
		36.1		0.8		25.0		0.4
Total	$	653.5	$	20.9	$	1,056.5	$	16.0

As noted in the “Results of Operations” section, included in 2003 and 2002 net realized losses were impairment write-downs of $10.5 million and $139.7 million, respectively, which are excluded from the table above. There were no impairment write-downs during 2004. The remaining net realized losses included in the 2004, 2003 and 2002 Consolidated Statements of Operations were the result of security sales made in the usual course of business in order to achieve Ambac’s investment objectives for the Financial Guarantee and Financial Services investment portfolios as discussed above.

Ambac Financial Group, Inc. and Subsidiaries    16

Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following table provides the ratings distribution of the fixed income investment portfolio at December 31, 2004 and 2003 by segment:

Rating (1):	Financial Guarantee		Financial Services		Combined
2004:
AAA	79	%	90	%	84	%
AA	15		2		10
A	2		5		3
BBB	<1		3		1
Below investment grade	<1		<1		<1
Not rated	4		—		2
	100	%	100	%	100	%
2003:
AAA	75	%	92	%	83	%
AA	16		2		9
A	6		3		5
BBB	1		2		2
Below investment grade	<1		<1		<1
Not rated	1		—		<1
	100	%	100	%	100	%

⁽¹⁾ Ratings represent Standard & Poor’s classifications. If unavailable, Moody’s rating is used.

Short-term investments in the Financial Guarantee portfolio consisted primarily of notes and domestic and foreign currency denominated money market funds. Short-term investments in the Financial Services portfolio consisted of money market funds.

Ambac’s fixed income portfolio included securities covered by guarantees issued by Ambac Assurance (“insured securities”). The published ratings on these securities are triple-A by the major rating agencies as a result of the Ambac Assurance insurance policy and are reflected in the above table as AAA. Rating agencies do not publish separate underlying ratings (those ratings excluding the Ambac Assurance insurance) because the insurance cannot be legally separated from the underlying security by the insurer. Ambac obtains underlying ratings through ongoing dialog with rating agencies. In the event these underlying ratings are not updated or simply not available from the rating agencies, Ambac will assign an internal rating. At December 31, 2004, securities with a total carrying value of $1,038 million representing 7% of the investment portfolio with a weighted-average underlying rating of BBB+ was insured by Ambac. In determining this BBB+ rating, approximately $109 million of the securities were assigned internal ratings by Ambac.

Cash Flows. Net cash provided by operating activities was $949.7 million, $1,005.7 million and $776.8 million during 2004, 2003 and 2002, respectively. These cash flows were primarily provided by net insurance premium receipts of $976.9 million, $1,005.6 million, and $790.5 million in 2004, 2003 and 2002, respectively, partially offset by net claim payments of $18.9 million, $34.1 million and $9.3 million in 2004, 2003 and 2002, respectively, in the Financial Guarantee segment. Future net cash provided by operating activities will be impacted by the level of claim payments. 2005 claim payments are estimated to be approximately $93.8 million. Net cash provided by financing activities was $655.3 million, $69.1 million and $1,357.5 million during 2004, 2003 and 2002, respectively. Financing activities for the year ended 2004 and 2002 included $12.8 million and $1,685.0 million, respectively, in net investment and payment agreements issued (net of investment and payment agreement draws), which were provided primarily by the investment agreement business. Financing activities for the year ended 2004 included $885.2 million in long-term debt issued by variable interest entities consolidated under the provisions of FIN 46. Financing activities for the year ended 2003 included $223.1 million used primarily by the investment agreement business for net investment and payment agreement draws paid (net of investment and payment agreements issued). Financing activities for the year 2003 also included the proceeds from the issuance of long-term debt of $363.2 million and the payment for the repurchase of Ambac’s long-term debt of $200.0 million. Net cash used in investing activities was $1,609.6 million, $1,076.1 million and $2,185.1 million, respectively. These investing activities were primarily net purchases of investment securities during 2004, 2003 and 2002. Total cash used in operating, investing and financing activities was $4.6 million, $1.3 million and $50.8 million during 2004, 2003 and 2002, respectively.

SPECIAL PURPOSE AND VARIABLE INTEREST ENTITIES

In January 2003, the FASB released FIN 46. In December 2003, the FASB released a revision of FIN 46 (“FIN 46-R”), which includes substantial changes from the original FIN 46. FIN 46-R provides accounting and disclosure rules for determining whether certain entities should be consolidated in Ambac’s Consolidated Financial Statements. As permitted, Ambac adopted FIN 46-R at December 31, 2004. An entity is subject to FIN 46-R, and is called a Variable Interest Entity (“VIE”), if it has (i) equity that is insufficient to permit the entity to finance its activities without additional subordinated financial support from other parties or (ii) equity investors that cannot make significant decisions about the entity’s operations or that do not absorb the expected losses or receive the expected returns of the entity. A VIE is consolidated by its primary beneficiary, which is the party that has a majority of the expected losses or a majority of the expected residual returns of the VIE or both. All other entities not considered VIEs are evaluated for consolidation under existing guidance.

Ambac has involvement with special purpose entities, including VIEs in the following ways. First, Ambac is a provider of financial guarantee insurance for various securitized asset-backed debt obligations. Second, Ambac has sponsored two special purpose entities that issue medium-term notes

17    Ambac Financial Group, Inc. and Subsidiaries

(“MTNs”) to fund the purchase of certain financial assets. As discussed in detail below, these Ambac sponsored special purpose entities are considered Qualifying Special Purpose Entities (“QSPEs”). Lastly, Ambac has a beneficial interest in a variable interest entity that purchases fixed rate municipal bonds with proceeds from the issuance of floating rate short term beneficial interests as discussed in detail below.

Financial Guarantees. Ambac provides financial guarantee insurance to securitized asset-backed debt obligations of special purpose entities, including VIEs. Ambac’s primary variable interest exists through this financial guarantee insurance contract. The transaction structure provides certain financial protection to Ambac. This financial protection can take several forms, however, the most common are over-collateralization, first loss retention and excess spread. In the case of over-collateralization (i.e., the principal amount of the securitized assets exceeds the principal amount of the structured finance obligations guaranteed by Ambac Assurance), the structure allows the transaction to experience defaults among the securitized assets before a default is experienced on the structured finance obligations that have been guaranteed by Ambac. In the case of first loss retention, the financial guarantee insurance policy only covers a senior layer of losses on debt issued by special purpose entities, including VIEs. The first loss with respect to the assets is either retained by the seller or sold off in the form of equity or mezzanine debt to other investors. In the case of excess spread, the financial assets contributed to special purpose entities, including VIEs, generate interest cash flows that are in excess of the interest payments on the related debt. All or a portion of this excess spread accumulates and is available to absorb losses in the transaction or is applied to create over-collateralization.

As of December 31, 2004, Ambac is the primary beneficiary and therefore consolidated VIEs under three transactions, as a result of providing financial guarantees to these entities. Ambac consolidated these entities since the structural financial protections are outside the VIEs. These structural protections, had they existed inside the VIEs, would have absorbed a majority of the VIEs’ expected losses and consequently Ambac would not have consolidated these entities. All consolidated VIEs are bankruptcy remote special purpose financing entities created to facilitate the sale of notes guaranteed by Ambac Assurance. Ambac is not primarily liable for the debt obligations of these entities. Ambac would only be required to make payments on these debt obligations in the event that the issuer defaults on any principal or interest due. Additionally, Ambac’s creditors do not have rights with regard to the assets of these VIEs.

Proceeds from the note issuance of the first VIE transaction, which closed in 2002, were used to purchase senior mortgage-backed floating rate notes of a Korean mortgage-backed securities issuer. Protections afforded Ambac Assurance in this transaction were in the form of a reserve fund and the issuance of subordinated debt. Ambac Assurance will pay claims under its financial guarantee only in the event that losses on the mortgage assets of the Korean issuer reduce the reserve fund to zero and exceed the principal amount of the subordinated notes. Total long-term debt outstanding under this note issuance was $119.5 million with a maturity date of December 3, 2022 and a variable rate of interest which was 2.30% and 1.64% at December 31, 2004 and 2003, respectively.

Proceeds from the note issuances of the other transactions, both of which closed in 2004, were used to purchase notes issued by special purpose reinsurance companies in connection with their reinsurance of defined blocks of life insurance contracts. Protections afforded Ambac Assurance were in the form of capital contributed to the reinsurance companies and the issuance of subordinated debt by the VIEs. Ambac Assurance will pay claims under it financial guarantees in these transactions if cash flows generated under the reinsurance agreements and the proceeds from the contributed capital and subordinated debt are insufficient to repay the noteholders. Total debt outstanding under these note issuances were $954.9 million at December 31, 2004, with maturity dates ranging from April 15, 2016 to February 4, 2025. At December 31, 2004 the interest rate on these notes ranged from 2.38% to 5.11%. Under one of these transactions, Ambac is subject to potential consolidation of an additional $350 million of assets and liabilities in connection with future utilization of the VIE by the reinsurer.

The following table provides supplemental information about the combined assets and liabilities associated with the VIEs discussed above. The assets and liabilities of these VIEs are consolidated into the respective Balance Sheet captions.

	At December 31,
(Dollars in millions)	2004		2003
Assets:
Cash	$	0.7	$	0.1
Loans		727.3		—
Investment in fixed income securities		346.1		189.2
Investment income due and accrued		2.3		0.2
Total	$	1,076.4	$	189.5
Liabilities:
Long-term debt	$	1,074.3	$	189.2
Other liabilities		2.1		0.3
Total	$	1,076.4	$	189.5

Disclosures made in Note 3, “Investments,” include investments in fixed income securities for all three VIE transactions. At December 31, 2004, the loan balance outstanding for one VIE transaction was $727.3 million with a fixed interest rate of 4.906% and an expected final maturity date of April 2011.

Qualified Special Purpose Entities. 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. These entities meet the characteristics of QSPEs in accordance with Statement of Financial Accounting Standards No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities” (“SFAS 140”). QSPEs are not subject to the requirements of FIN 46-R and accordingly are not consolidated in Ambac’s financial statements. The QSPEs are legal entities that are demonstrably distinct from Ambac. Ambac, its affiliates or its agents cannot unilaterally dissolve the QSPEs. The QSPEs permitted activities are limited to those outlined below.

As of December 31, 2004, there have been 14 individual transactions (one in 2004) processed through the QSPEs of which 10 are outstanding. In each case, Ambac sells fixed income debt obligations to the QSPEs. These transactions are true sales based upon the bankruptcy remote nature of the QSPE and the absence of any agreement or obligation for Ambac to repurchase

Ambac Financial Group, Inc. and Subsidiaries    18

Management’s Discussion and Analysis of Financial Condition and Results of Operations

or redeem assets of the QSPE. The purchase by the QSPE is financed through the issuance of MTNs, which are collateralized by the purchased assets. The cash flows of the MTNs approximately match the cash flows of the assets purchased. Derivative contracts (interest rate and currency swaps) may be used for hedging purposes only. Derivative hedges are established at the time MTNs are issued to purchase financial assets. The activities of the QSPEs are contractually limited to purchasing assets from Ambac, issuing MTNs to fund such purchase, 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, 2004, Ambac Assurance had financial guarantee insurance policies issued for all assets and MTNs owned and outstanding by the QSPEs.

Ambac’s exposures under these financial guarantee insurance policies as of December 31, 2004 and December 31, 2003 are included in the disclosure in Note 15 “Guarantees in Force.” Pursuant to the terms of Ambac Assurance’s insurance policy, insurance premiums are paid to Ambac Assurance by the QSPEs and are earned in a manner consistent with other insurance policies, over the risk period. Any losses incurred would be included in Ambac’s Consolidated Statements of Operations. Under the terms of an Administrative Agency Agreement, Ambac provides certain administrative duties, primarily collecting amounts due on the obligations and making interest payments on the MTNs.

Assets sold to the QSPEs during 2004, 2003 and 2002 were $195.0 million, $250.0 million and $350.0 million, respectively. No gains or losses were recognized on these sales. As of December 31, 2004, the estimated fair value of financial assets, MTN liabilities and derivative hedge liabilities were $2,011.9 million, $1,820.9 million and $171.4 million, respectively. When market quotes are not available, estimated fair value is determined utilizing valuation models. These models include estimates, made by Ambac management, which utilize current market information. The valuation results from these models could differ materially from amounts that would actually be realized in the market. Ambac Assurance received gross premiums for issuing financial guarantee policies on the assets, MTNs and derivative contracts of $6.0 million, $5.3 million and $19.3 million for the years ended December 31, 2004, 2003 and 2002, respectively. Ambac also received fees for providing other services amounting to $0.4 million, $0.5 million and $0.1 million for 2004, 2003 and 2002, respectively.

VIE Beneficial Interest. Ambac owns a beneficial interest in a special purpose entity that meets the definition of a VIE. This entity has issued floating rate beneficial interests to investors and invested the proceeds in fixed income municipal investment securities. Ambac is the primary beneficiary of this entity as a result of its beneficial interest. The fixed income municipal investment securities, which are reported as Investments in fixed income securities, at fair value on the Consolidated Balance Sheets, were $257.3 million and $254.8 million as of December 31, 2004 and 2003. The beneficial interests issued to third parties, are reported as Obligations under investment and payment agreements on the Consolidated Balance Sheets, were $249.1 million and $249.8 million as of December 31, 2004 and 2003. As of December 31, 2004 and 2003, the interest rates on these beneficial interests ranged from 0.87% to 2.03% and from 0.68% to 1.42%, respectively.

ACCOUNTING STANDARDS

Please refer to Note 2, “Significant Accounting Policies” for a discussion of the impact of recent accounting pronouncements on Ambac’s financial condition and results of operations.

RISK MANAGEMENT

In the ordinary course of business, Ambac, manages a variety of risks, principally 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.

Credit Risk. Ambac is exposed to credit risk in various capacities including as an issuer of financial guarantees, as counterparty to derivative and other financial contracts and as a holder of investment securities. Ambac’s Portfolio Risk Management Committee (“PRMC”) employs various procedures and controls to monitor and manage credit risk. The PRMC is comprised of senior risk professionals and senior management of Ambac. 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.

All financial guarantees and structured credit derivatives issued are subject to a formal underwriting process. Various factors affecting the creditworthiness of the underlying obligation are evaluated during the underwriting process. Senior credit personnel approve all transactions prior to issuing a financial guarantee. Subsequent to issuance of a financial guarantee, Ambac periodically performs reviews of exposures according to a schedule based on the risk profile of the guaranteed obligations. Proactive credit remediation can help secure rights and remedies which mitigate losses in the event of default.

Ambac manages credit risk associated with its investment portfolio through adherence to specific investment guidelines. These guidelines establish limits based upon single risk concentration and minimum credit rating standards. Additionally, senior credit personnel monitor the portfolio on a continuous basis. Credit risk relating to derivative positions (other than structured credit derivatives discussed below) primarily concern counterparty default. Counterparty default exposure is mitigated through the use of industry standard collateral posting agreements. For counterparties subject to such collateral posting agreements, collateral is posted when a derivative counterparty’s credit exposure exceeds contractual limits. Please refer to Note 3 “Investments” for disclosures of collateral posted to Ambac under derivative contracts.

19    Ambac Financial Group, Inc. and Subsidiaries

Market Risk. Market risk represents the potential for losses that may result from changes in the value of a financial instrument as a result of changes in market conditions. The primary market risks that would impact the value of Ambac’s financial instruments are interest rate risk, basis risk (e.g., taxable interest rates relative to tax-exempt interest rates, discussed below) and credit spread risk. Below we discuss each of these risks and the specific types of financial instruments impacted. Senior managers in Ambac’s Risk Analysis and Reporting group are responsible for monitoring risk limits and applying risk measurement methodologies. The estimation of potential losses arising from adverse changes in market conditions is a key element in managing market risk. Ambac utilizes various systems, models and stress test scenarios to monitor and manage market risk. This process includes frequent analyses of both parallel and non-parallel shifts in the yield curve, “Value-at-Risk” (“VaR”) and changes in credit spreads. These models include estimates, made by management, which utilize current and historical market information. The valuation results from these models could differ materially from amounts that would actually be realized in the market.

Financial instruments that may be adversely affected by changes in interest rates consist primarily of investment securities, loans, investment agreement liabilities, obligations under payment agreements, long-term debt, and derivative contracts used for hedging purposes. The following table summarizes the estimated change in fair value (based primarily on the valuation models discussed above) on these financial instruments, assuming immediate changes in interest rates at specified levels at December 31, 2004 and 2003:

(Dollars in millions)
Change in Interest Rates	Estimated Net Fair Value		Estimated Change in Net Fair Value
2004:
300 basis point rise	$	5,935	$	(1,616	)
200 basis point rise		6,555		(996	)
100 basis point rise		7,096		(455	)
Base scenario		7,551		—
100 basis point decline		7,928		377
200 basis point decline		8,222		671
300 basis point decline		8,434		883
2003:
300 basis point rise	$	4,866	$	(1,713	)
200 basis point rise		5,479		(1,100	)
100 basis point rise		6,049		(530	)
Base scenario		6,579		—
100 basis point decline		7,100		521
200 basis point decline		7,581		1,002
300 basis point decline		8,021		1,442

Ambac, through its subsidiary Ambac Financial Services, is a provider of interest rate swaps to states, municipalities and their authorities and other entities in connection with their financings. Ambac Financial Services manages its municipal interest rate swaps business with the goal of being market neutral to changes in overall interest rates, while seeking to profit from retaining some basis risk. Ambac’s municipal interest rate swap portfolio may be adversely affected by changes in basis. If actual or projected tax-exempt interest rates change in relation to taxable interest rates, Ambac will experience a mark-to-market gain or loss. Most municipal interest rate swaps transacted by Ambac Financial Services contain provisions that are designed to protect Ambac against certain forms of tax reform, thus mitigating its basis risk. The estimation of potential losses arising from adverse changes in market relationships, known as VaR, is a key element in management’s monitoring of basis risk for the municipal interest rate swap portfolio. Ambac has developed a VaR methodology to estimate potential losses over a specified holding period and based on certain probabilistic assessments. Ambac’s methodology estimates VaR using a 300-day historical “look back” period. This means that changes in market values are simulated using market inputs from the past 300 days. For the years ended December 31, 2004 and 2003, Ambac’s VaR, for its interest rate swap portfolio, calculated at a ninety-nine percent confidence level, averaged approximately $6.6 million and $3.2 million, respectively. Ambac’s VaR ranged from a high of $6.9 million to a low of $6.2 million in 2004, and from a high of $6.9 million to a low of $1.2 million in 2003. Ambac supplements its VaR methodology, which is a good risk management tool in normal markets, by performing rigorous stress testing to measure the potential for losses in abnormally volatile markets. These stress tests include (i) parallel and non-parallel shifts in the yield curve and (ii) immediate changes in normal basis relationships, such as those between taxable and tax-exempt markets.

Financial instruments that may be adversely affected by changes in credit spreads include Ambac’s outstanding structured credit derivative and total return contracts. Ambac, through its subsidiary Ambac Credit Products, enters into structured credit derivative contracts. These contracts require Ambac Credit Products to make payments upon the occurrence of certain defined credit events relating to an underlying obligation (generally a fixed income obligation). If credit spreads of the underlying obligations change, the market value of the related structured credit derivative changes. As such, Ambac Credit Products could experience mark-to-market gains or losses. Market liquidity could also impact valuations. Changes in credit spreads are generally caused by changes in the market’s perception of the credit quality of the underlying obligations. Ambac Credit Products structures its contracts with partial hedges from various financial institutions or with first loss protection. Such structuring mitigates Ambac Credit Products’ risk of loss and reduces the price volatility of these financial instruments. Management models the potential impact of credit spread changes on the value of its contracts.

Ambac, through its subsidiary Ambac Capital Services, enters into total return swap contracts. These contracts require Ambac Capital Services to pay a specified spread in excess of LIBOR in exchange for receiving the total return of an underlying fixed income obligation over a specified period of time. If credit spreads of the underlying obligations change, the market value of the related total return swaps changes and Ambac Capital Services could experience mark-to-market gains or losses.

Ambac Financial Group, Inc. and Subsidiaries    20

Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following table summarizes the estimated change in fair value (based primarily on the valuation models discussed above) on the net balance of Ambac’s net structured credit and total return swap derivative positions assuming immediate changes in credit spreads at specified levels at December 31, 2004 and 2003:

(Dollars in millions)
Change in Credit Spreads	Estimated Net Fair Value			Estimated Unrealized Gain/(Loss)
2004:
75 basis point widening	$	(82	)	$	(84	)
50 basis point widening		(54	)		(56	)
25 basis point widening		(26	)		(28	)
Base scenario		(2	)		—
25 basis point narrowing		30			28
50 basis point narrowing		50			48
75 basis point narrowing		59			57
2003:
75 basis point widening	$	(87	)	$	(58	)
50 basis point widening		(67	)		(38	)
25 basis point widening		(48	)		(19	)
Base scenario		(29	)		—
25 basis point narrowing		(10	)		19
50 basis point narrowing		8			37
75 basis point narrowing		23			52

Liquidity Risk. Liquidity risk relates to the possible inability to satisfy contractual obligations when due. This risk is present in financial guarantee contracts, structured credit derivatives, investment agreements, interest rate swaps and futures contracts. Ambac Assurance manages its liquidity risk by maintaining a comprehensive daily analysis of projected cash flows. Additionally, Ambac Assurance maintains a minimum level of cash and short-term investments at all times. Ambac Credit Products manages the liquidity risk inherent in the structured credit derivative portfolio by holding cash and short-term investments. The investment agreement business manages liquidity risk by matching the maturity schedules of its invested assets, including hedges, with the maturity schedules of its investment agreement liabilities. Ambac Financial Services maintains cash and short-term investments and closely matches the dates swap payments are made and received. See additional discussion in “Liquidity and Capital Resources” section.

Operational Risk. Operational risk relates to the potential for loss caused by a breakdown in information, communication and settlement systems. Ambac mitigates operational risk by maintaining systems (and system backup) and procedures to monitor transactions and positions, documentation and confirmation of transactions, and compliance with regulations.

Legal Risk. Legal risks attendant to Ambac’s businesses include uncertainty with respect to the enforceability of the obligations insured by Ambac Assurance and the security therefor, as well as uncertainty with respect to the enforceability of the obligations of Ambac’s counterparties, including contractual provisions intended to reduce exposure by providing for the offsetting or netting of mutual obligations. Ambac seeks to remove or minimize such uncertainties through continuous consultation with internal and external legal advisers to analyze and understand the nature of legal risk, to improve documentation and to strengthen transaction structure.

21    Ambac Financial Group, Inc. and Subsidiaries

Management’s Responsibility for Financial Information

The management of Ambac Financial Group, Inc. is responsible for the integrity and objectivity of the Consolidated Financial Statements and all other financial information presented in this Annual Report and for assuring that such information fairly presents the consolidated financial position and operating results of Ambac Financial Group, Inc. The accompanying Consolidated Financial Statements have been prepared in conformity with U.S. generally accepted accounting principles using management’s best estimates and judgment. The financial information presented elsewhere in this Annual Report is consistent with that in the Consolidated Financial Statements.

The independent registered public accounting firm audits Ambac Financial Group, Inc.’s Consolidated Financial Statements in accordance with the standards of the Public Company Accounting Oversight Board.

The Audit Committee of the Board of Directors, comprised solely of independent directors, meets regularly with financial and risk management, the internal auditors and the registered public accounting firm to review the work and procedures of each. The registered public accounting firm and the internal auditors have free access to the Audit Committee, without the presence of management, to discuss the results of their work and their considerations of Ambac and its subsidiaries and the quality of Ambac Financial Group, Inc.’s financial reporting. The Audit Committee appoints the registered public accounting firm, subject to stockholder approval.

Management’s Report on Internal Control Over Financial Reporting

The management of Ambac Financial Group, Inc. (“Ambac”) is responsible for establishing and maintaining adequate internal control over financial reporting. Ambac’s internal control over financial reporting is a process designed under the supervision of the chief executive officer and chief financial officer, and effected by Ambac’s Board of Directors, management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of Ambac’s financial statements for external reporting purposes in accordance with U.S. generally accepted accounting principles. Ambac’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of assets of Ambac; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with U.S. generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of Ambac; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of Ambac’s assets that could have a material effect on the financial statements.

As of December 31, 2004, management conducted an assessment of the effectiveness of Ambac’s internal control over financial reporting based on the framework established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”). Based on this evaluation in relation to the criteria established in Internal Control — Integrated Framework, management concluded that Ambac’s internal control over financial reporting is effective as of December 31, 2004.

Management’s assessment of the effectiveness of our internal control over financial reporting as of December 31, 2004 has been audited by KPMG LLP, an independent registered public accounting firm, as stated in their report which is included herein, which expresses unqualified opinions on management’s assessment and on the effectiveness of Ambac’s internal control over financial reporting as of December 31, 2004.

Ambac Financial Group, Inc. and Subsidiaries    22

Report of Independent Registered Public Accounting Firm

The Board of Directors and Stockholders

Ambac Financial Group, Inc.:

We have audited management’s assessment, included in the accompanying Management’s Report on Internal Control Over Financial Reporting, that Ambac Financial Group, Inc. and subsidiaries (the “Company” or “Ambac”) maintained effective internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

In our opinion, management’s assessment that Ambac maintained effective internal control over financial reporting as of December 31, 2004, is fairly stated, in all material respects, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Also, in our opinion, Ambac maintained, in all material respects, effective internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Ambac as of December 31, 2004 and 2003, and the related consolidated statements of operations, stockholders’ equity and cash flows for each of the years in the three-year period ended December 31, 2004, and our report dated March 2, 2005, expressed an unqualified opinion on those consolidated financial statements.

New York, New York

March 2, 2005

23    Ambac Financial Group, Inc. and Subsidiaries

Report of Independent Registered Public Accounting Firm

The Board of Directors and Stockholders

Ambac Financial Group, Inc.:

We have audited the accompanying consolidated balance sheets of Ambac Financial Group, Inc. and subsidiaries as of December 31, 2004 and 2003, and the related consolidated statements of operations, stockholders’ equity and cash flows for each of the years in the three-year period ended December 31, 2004. These consolidated financial statements are the responsibility of Ambac Financial Group, Inc.’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Ambac Financial Group, Inc. and subsidiaries as of December 31, 2004 and 2003, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2004, in conformity with U.S. generally accepted accounting principles.

As discussed in Note 2 to the consolidated financial statements, in 2003 Ambac Financial Group, Inc. changed its methods of accounting for variable interest entities and stock-based compensation.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Ambac Financial Group, Inc.’s internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated March 2, 2005 expressed an unqualified opinion on management’s assessment of, and the effective operation of, internal control over financial reporting.

New York, New York

March 2, 2005

Ambac Financial Group, Inc. and Subsidiaries    24

Consolidated Balance Sheets

(Dollars in Thousands, Except Share Amounts)	December 31,
	2004		2003
Assets:
Investments:
Fixed income securities, at fair value (amortized cost of $13,425,475 in 2004 and $12,592,398 in 2003)	$	13,901,218	$	13,049,219
Fixed income securities pledged as collateral, at fair value (amortized cost of $345,195 in 2004 and $662,046 in 2003)		341,742		661,422
Short-term investments, at cost (approximates fair value)		521,226		250,382
Other (cost of $3,731 in 2004 and $4,528 in 2003)		4,234		4,417
Total investments		14,768,420		13,965,440
Cash		19,957		24,539
Securities purchased under agreements to resell		353,000		54,015
Receivable for securities sold		1,319		4,425
Investment income due and accrued		162,506		159,680
Reinsurance recoverable on paid and unpaid losses		16,765		3,030
Prepaid reinsurance		297,330		325,461
Deferred acquisition costs		184,766		175,296
Loans		1,405,700		837,981
Derivative assets		1,297,972		1,146,408
Other assets		77,523		51,039
Total assets	$	18,585,258	$	16,747,314
Liabilities and Stockholders’ Equity:
Liabilities:
Unearned premiums	$	2,778,893	$	2,545,490
Losses and loss expense reserve		254,055		189,414
Ceded reinsurance balances payable		18,248		15,383
Obligations under investment and payment agreements		6,813,914		6,545,759
Obligations under investment repurchase agreements		266,806		530,644
Securities sold under agreement to repurchase		—		225,500
Deferred income taxes		217,373		171,058
Current income taxes		16,406		43,176
Long-term debt		1,866,207		980,926
Accrued interest payable		71,058		74,235
Derivative liabilities		1,049,103		946,178
Other liabilities		208,732		222,163
Payable for securities purchased		6		2,830
Total liabilities		13,560,801		12,492,756
Stockholders’ equity:
Preferred stock, par value $0.01 per share; authorized shares— 4,000,000; issued and outstanding shares—none		—		—
Common stock, par value $0.01 per share; authorized shares— 350,000,000 at December 31, 2004 and 200,000,000 at December 31, 2003; issued shares—108,915,944 at December 31, 2004 and 107,144,148 at December 31, 2003		1,089		1,073
Additional paid-in capital		694,465		606,468
Accumulated other comprehensive income		296,814		266,919
Retained earnings		4,032,089		3,380,098
Common stock held in treasury at cost, 0 shares at December 31, 2004 and at December 31, 2003		—		—
Total stockholders’ equity		5,024,457		4,254,558
Total liabilities and stockholders’ equity	$	18,585,258	$	16,747,314

See accompanying Notes to Consolidated Financial Statements.

25    Ambac Financial Group, Inc. and Subsidiaries

Consolidated Statements of Operations

	Years Ended December 31,
(Dollars in Thousands, Except Share Amounts)	2004			2003			2002
Revenues:
Financial Guarantee:
Gross premiums written	$	1,047,811		$	1,143,703		$	904,032
Ceded premiums written		(70,946	)		(138,146	)		(113,542	)
Net premiums written	$	976,865		$	1,005,557		$	790,490
Net premiums earned		716,659			620,317			471,534
Other credit enhancement fees		47,326			46,933			28,775
Net premiums earned and other credit enhancement fees		763,985			667,250			500,309
Net investment income		361,086			321,089			297,297
Net realized investment gains		30,004			40,190			40,918
Net mark-to-market gains (losses) on credit derivative contracts		17,734			23			(27,877	)
Other (loss) income		(4,102	)		5,026			5,531
Financial Services:
Interest from investment and payment agreements		198,800			211,974			255,007
Derivative products		35,775			20,600			17,376
Net realized investment gains (losses)		5,099			(1,981	)		(134,097	)
Net mark-to-market (losses) gains on derivative hedge contracts		(3,329	)		779			(839	)
Corporate:
Net investment income		1,674			7,026			3,537
Net realized investment (losses) gains		(18	)		232			1,482
Total revenues		1,406,708			1,272,208			958,644
Expenses:
Financial Guarantee:
Losses and loss expenses		69,600			53,400			26,700
Underwriting and operating expenses		106,563			92,035			76,548
Interest expense on variable interest entity notes		5,144			—			—
Financial Services:
Interest from investment and payment agreements		168,943			196,318			231,304
Other expenses		14,671			12,103			9,867
Interest		54,322			54,201			43,724
Corporate		10,683			14,562			7,170
Total expenses		429,926			422,619			395,313
Income before income taxes		976,782			849,589			563,331
Provision for income taxes		250,942			221,490			131,403
Income from continuing operations		725,840			628,099			431,928
Discontinued Operations:
(Loss) income from discontinued operations		(1,349	)		(6,976	)		859
Income tax (benefit) expense		(60	)		2,208			193
Net (loss) income from discontinued operations		(1,289	)		(9,184	)		666
Net income	$	724,551		$	618,915		$	432,594
Earnings per share:
Income from continuing operations	$	6.62		$	5.90		$	4.07
Discontinued operations	$	(0.01	)	$	(0.09	)	$	0.01
Net income	$	6.61		$	5.81		$	4.08
Earnings per diluted share:
Income from continuing operations	$	6.54		$	5.74		$	3.96
Discontinued operations	$	(0.01	)	$	(0.08	)	$	0.01
Net income	$	6.53		$	5.66		$	3.97
Weighted average number of common shares outstanding:
Basic		109,602,601			106,553,103			105,951,603
Diluted		110,898,854			109,409,776			109,066,046

See accompanying Notes to Consolidated Financial Statements.

Ambac Financial Group, Inc. and Subsidiaries    26

Consolidated Statements of Stockholders’ Equity

	Years Ended December 31,
(Dollars in Thousands)	2004					2003						2002
Retained Earnings:
Balance at January 1	$	3,380,098				$	2,820,281					$	2,403,473
Net income		724,551		$	724,551		618,915		$	618,915			432,594		$	432,594
Dividends declared—common stock		(50,910	)				(44,739	)					(40,251	)
Exercise of stock options		(21,650	)				(14,359	)					24,465
Balance at December 31	$	4,032,089				$	3,380,098					$	2,820,281
Accumulated Other Comprehensive Income:
Balance at January 1	$	266,919				$	265,427					$	62,476
Unrealized gains (losses) on securities, $15,131, $(10,937) and $339,039, pre-tax in 2004, 2003 and 2002, respectively (1)					8,368					(5,923	)					214,943
Gains (losses) on derivative hedges, $29,725, $6,777, and $ (24,461) pre-tax in 2004, 2003 and 2002					17,851					4,066						(14,171	)
Foreign currency gain					3,676					3,349						2,179
Other comprehensive income		29,895			29,895		1,492			1,492			202,951			202,951
Total comprehensive income				$	754,446				$	620,407					$	635,545
Balance at December 31	$	296,814				$	266,919					$	265,427
Preferred Stock:
Balance at January 1 and December 31	$	—				$	—					$	—
Common Stock:
Balance at January 1	$	1,073				$	1,062					$	1,060
Issuance of stock		16					11						2
Balance at December 31	$	1,089				$	1,073					$	1,062
Additional Paid-in Capital:
Balance at January 1	$	606,468				$	550,289					$	538,135
Employee benefit plans		48,722					30,445						16,320
Issuance of stock		43,973					30,405						4,287
Capital issuance costs		(4,698	)				(4,671	)					(8,453	)
Balance at December 31	$	694,465				$	606,468					$	550,289
Common Stock Held in Treasury at Cost:
Balance at January 1	$	0				$	(11,880	)				$	(21,456	)
Cost of shares acquired		(51,781	)				(20,247	)					(37,907	)
Shares issued under equity plans		51,781					32,127						47,483
Balance at December 31	$	0				$	0					$	(11,880	)
Total Stockholders’ Equity at December 31	$	5,024,457				$	4,254,558					$	3,625,179
(1)      Disclosure of reclassification amount:
Unrealized holding gains arising during period	$	32,062				$	26,168					$	154,065
Less: reclassification adjustment for net gains (losses) included in net income		23,694					32,091						(60,878	)
Net unrealized gains (losses) on securities	$	8,368				$	(5,923	)				$	214,943

See accompanying Notes to Consolidated Financial Statements.

27    Ambac Financial Group, Inc. and Subsidiaries

Consolidated Statements of Cash Flows

	Years Ended December 31,
(Dollars in Thousands)	2004			2003			2002
Cash Flows from Operating Activities:
Net income	$	724,551		$	618,915		$	432,594
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		2,890			3,165			3,466
Amortization of bond premium and discount		(4,475	)		18,361			8,872
Current income taxes		10,412			16,320			(38,480	)
Deferred income taxes		19,990			(6,815	)		(50,648	)
Deferred acquisition costs		(9,470	)		(1,241	)		(10,578	)
Unearned premiums, net		261,534			387,308			320,104
Losses and loss expenses		50,906			19,089			17,202
Ceded reinsurance balances payable		2,865			(1,547	)		6,784
Investment income due and accrued		(2,826	)		(17,033	)		15,002
Accrued interest payable		(3,177	)		(7,311	)		(2,973	)
Net realized investment (gains) losses		(35,085	)		(38,441	)		91,697
Other, net		(68,413	)		14,959			(16,270	)
Net cash provided by operating activities		949,702			1,005,729			776,772
Cash Flows from Investing Activities:
Proceeds from sales of bonds		2,941,467			3,632,072			3,380,488
Proceeds from matured bonds		1,451,311			2,634,394			2,204,670
Proceeds from the sale of Cadre Financial Services, Inc.		3,676			—			—
Purchases of bonds		(4,862,050	)		(7,699,387	)		(7,588,477	)
Change in short-term investments		(270,844	)		145,379			19,241
Securities purchased under agreements to resell		(298,985	)		206,803			(249,618	)
Loans, net		(567,719	)		5,828			57,385
Other, net		(6,415	)		(1,194	)		(8,740	)
Net cash used in investing activities		(1,609,559	)		(1,076,105	)		(2,185,051	)
Cash Flows from Financing Activities:
Dividends paid		(50,910	)		(44,739	)		(40,251	)
Securities sold under agreements to repurchase		(225,500	)		89,081			(292,637	)
Proceeds from issuance of investment and payment agreements		2,053,150			1,933,922			3,828,547
Payments for investment and payment agreement draws		(2,040,327	)		(2,157,006	)		(2,143,557	)
Proceeds from issuance of long-term debt		885,217			363,188			—
Payment for buyback of long-term debt		—			(200,000	)		—
Capital issuance costs		(4,698	)		(4,671	)		(8,452	)
Net cash collateral received		16,062			47,028			—
Issuance of common stock		43,989			30,416			4,289
Purchases of treasury stock		(51,781	)		(20,247	)		(37,907	)
Proceeds from sale of treasury stock		30,073			32,127			47,483
Net cash provided by financing activities		655,275			69,099			1,357,515
Net Cash Flow		(4,582	)		(1,277	)		(50,764	)
Cash at January 1		24,539			25,816			76,580
Cash at December 31	$	19,957		$	24,539		$	25,816
Supplemental Disclosures of Cash Flow Information:
Cash paid during the year for:
Income taxes	$	180,333		$	175,624		$	159,500
Interest expense on long-term debt	$	58,223		$	54,423		$	48,260
Interest expense on investment agreements	$	157,576		$	180,287		$	218,195

See accompanying Notes to Consolidated Financial Statements.

Ambac Financial Group, Inc. and Subsidiaries    28

Notes to Consolidated Financial Statements

(Dollar Amounts in Thousands, Except Share Amounts)

1 BACKGROUND

Ambac Financial Group, Inc. is a holding company whose subsidiaries provide financial guarantees and financial services to clients in both the public and private sectors around the world. Ambac’s principal operating subsidiary, Ambac Assurance Corporation, a leading provider of financial guarantees for public finance and structured finance obligations, has earned triple-A ratings, the highest ratings available from Moody’s Investors Service, Inc., Standard & Poor’s Ratings Services, Fitch Inc., and Rating and Investment Information, Inc. Ambac’s Financial Services segment provides financial and investment products including investment agreements, interest rate swaps, total return swaps and funding conduits, principally to its clients, which include municipalities and other public entities, health care organizations and asset-backed issuers.

2 SIGNIFICANT ACCOUNTING POLICIES

The accompanying consolidated financial statements of Ambac and subsidiaries have been prepared on the basis of U.S. generally accepted accounting principles (“GAAP”). The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported revenues and expenses during the reporting period. Actual results could differ from those estimates. The significant accounting policies of Ambac are described below:

Consolidation: The Consolidated Financial Statements include the accounts of Ambac and its subsidiaries and variable interest entities for which Ambac is the primary beneficiary. All significant intercompany balances have been eliminated.

Investments: Ambac’s investment portfolio is accounted for on a trade-date basis and consists primarily of investments in fixed income securities that are considered available-for-sale and are carried at fair value. Fair value is based primarily on quotes obtained from independent market sources. When quotes are not available, valuation models are used to estimate fair value. These models include estimates, made by management, which utilize current market information. The valuation results from these models could differ materially from amounts that would actually be realized in the market. Short-term investments are carried at cost, which approximates fair value. Unrealized gains and losses, net of deferred income taxes, are included as a component of “Accumulated Other Comprehensive Income” in stockholders’ equity and are computed using amortized cost as the basis. If management believes that an unrealized loss is “other than temporary,” the carrying value of the investment is reduced and a realized investment loss is recorded in the Consolidated Statement of Operations. For purposes of computing amortized cost, premiums and discounts are accounted for using the interest method. For bonds purchased at a price below par value, discounts are accreted over the remaining term of the securities. For bonds purchased at a price above par value that have call features, premiums are amortized to the first call date. For premium bonds that do not have call features, such premiums are amortized over the remaining terms of the securities. Premiums and discounts on mortgage-backed and asset-backed securities are adjusted for the effects of actual and anticipated prepayments. Realized gains and losses on the sale of investments are determined on the basis of specific identification.

Securities Purchased under Agreements to Resell and Securities Sold Under Agreements to Repurchase: Securities purchased under agreements to resell are collateralized investment transactions, and are recorded at their contracted resale amounts, plus accrued interest. Ambac takes possession of the collateral underlying those agreements and monitors its market value on a daily basis and, when necessary, requires prompt transfer of additional collateral to reflect current market value. Securities sold under agreements to repurchase are collateralized financing transactions and are recorded at their contracted resale amounts, plus accrued interest. Ambac nets securities purchased under agreements to resell and securities sold under agreements to repurchase that are executed with the same counterparty under legally enforceable netting agreements that meet the applicable netting criteria. At December 31, 2004 and 2003, collateral underlying securities purchased under agreements to resell had an average credit rating of triple-A and a weighted average maturity of less than 30 days and less than 90 days, respectively.

Deferred Acquisition Costs: Certain financial guarantee costs incurred, primarily related to the production of business, have been deferred. These costs include direct and indirect expenses related to underwriting, marketing and policy issuance, rating agency fees and premium taxes, net of reinsurance ceding commissions. The deferred acquisition costs are being amortized over the periods in which the related premiums are earned, and such amortization amounted to $25,260, $38,529 and $32,336 for 2004, 2003 and 2002, respectively. Deferred acquisition costs, net of such amortization, amounted to $9,470, $1,241 and $10,578 for 2004, 2003 and 2002, respectively.

Loans: Loans are reported at their outstanding unpaid principal balances, net of fair value hedge adjustments. These fair value hedge adjustments are discussed further in “Derivative Contracts used for Hedging Purposes” below. Interest income is accrued on the unpaid principal balance. Deferred fees are amortized to income over the contractual life of the loan using the interest method or the straight-line method if not materially different.

Losses and Loss Expenses: The Company provides financial guarantee insurance on certain debt obligations. This financial guarantee insurance is a promise to pay scheduled interest and principal if the issuer of the debt security fails to meet its obligation. The loss reserve policy for financial guarantee insurance discussed in this footnote relates only to the Company’s non-derivative insurance business. The policy for derivative contracts is discussed in the section entitled “Derivative Contracts.” Losses and loss expenses are based upon estimates of the

29    Ambac Financial Group, Inc. and Subsidiaries

ultimate aggregate losses inherent in the non-derivative financial guarantee portfolio as of the reporting date. The evaluation process for determining the level of reserves is subject to certain estimates and judgments. In most instances, claim payments are forecasted in advance of issuer default as a result of active surveillance of the insured book of business. Based upon Company experience, claim payments become probable and estimable once the issuer’s credit profile has migrated to certain impaired credit levels. The insured party has the right to a claim under Ambac’s financial guarantee insurance policy at the first scheduled debt service date of the defaulted obligation. As discussed below, the accounting for credit loss reserves is possibly subject to change.

The liability for losses and loss expenses consists of active credit and case basis credit reserves. Active credit reserves are for probable and estimable losses due to credit deterioration on insured credits that have not yet defaulted or been reported and are reflected on an undiscounted basis as of the reporting date. The establishment of reserves for exposures that have not yet defaulted is a common practice in the financial guarantee industry. However, the Company is aware that there are differences in the specific methodologies applied by other financial guarantors in establishing such reserves. Ambac’s active credit reserve is based on management’s on-going review of the non-derivative financial guarantee credit portfolio. Active surveillance of the insured portfolio enables Ambac’s Surveillance Group to track credit migration of insured obligations from period to period and prepare an adversely classified credit listing. The active credit reserve is established only for adversely classified credits. The criteria for an exposure to be included on the adversely classified credit listing includes the deterioration in an issuer’s financial condition, underperformance of the underlying collateral (for collateral dependent transactions such as mortgage-backed securitizations), problems with the servicer of the underlying collateral and other adverse economic events or trends. The servicer of the underlying collateral of a securitized credit is a consideration in assessing credit quality because the servicer’s performance can directly impact the performance of the related credit. For example, a servicer of a mortgage-backed securitization that does not remain current in their collection efforts could cause an increase in the delinquency and potential default of the underlying collateral. The active credit reserve is established through a process that begins with statistical estimates of probable losses inherent in the adversely classified credit portfolio. Statistical estimates are computed on each adversely classified credit. These statistical estimates are based upon: (i) Ambac’s internal system of credit ratings, which are analogous to the risk ratings of the major rating agencies; (ii) internally developed historical default information (taking into consideration ratings and average life of an obligation); (iii) internally developed loss severities; and (iv) the net par outstanding on the adversely classified credit. The loss severities and default information are based on rating agency information and are specific to each bond type and are established and approved by Ambac’s Portfolio Risk Management Committee. The Portfolio Risk Management Committee is comprised of senior risk management professionals and other senior management of Ambac. For certain credit exposures that have deteriorated significantly, Ambac will undertake additional monitoring and loss remediation efforts. Additional remediation can include various actions by the Company. The most common actions include obtaining detailed appraisal information on collateral, more frequent meetings with the issuer’s or servicer’s management to review operations, financial condition and financial forecasts and more frequent analysis of the issuer’s financial statements. For these credits the Company would use relevant information obtained from its remediation efforts to adjust the statistical estimate discussed above. Senior management meets at least quarterly with the Surveillance Group to review the status of their work to determine the adequacy of Ambac’s loss reserves and make any necessary adjustments. Active credit reserves were $120,802 and $132,181 at December 31, 2004 and 2003, respectively. The active credit reserves at December 31, 2004 and 2003 was comprised of 68 and 60 credits with net par outstanding of $7,574,223 and $3,705,103, respectively. Included in the calculation of active credit reserves at December 31, 2004 and 2003 was the consideration of $17,891 and $38,592, respectively, of reinsurance which would be due to Ambac from the reinsurers, upon default of the insured obligation.

Case basis credit reserves are for losses on insured obligations that have defaulted. We believe our definition of case base credit reserves differs from other financial guaranty industry participants. Upon the occurrence of a payment default, the related active credit reserve is transferred to case basis credit reserve. Additional provision for losses upon further credit deterioration of a case basis exposure are initially recorded through the active credit reserve and subsequently transferred to case basis credit reserves. Our case reserves represent the present value of anticipated loss and loss expense payments expected over the estimated period of default. Loss and loss expenses consider anticipated defaulted debt service payments, estimated expenses associated with settling the claims and estimated recoveries under collateral and subrogation rights. The estimate does not consider future installment premium receipts, as the likelihood of such receipts is remote. Ambac discounts these estimated net payments using discount rates that approximate the average taxable equivalent yield on our investment portfolio. Discount rates applied to case basis credit reserves were 6.0% and 6.5% at December 31, 2004 and 2003, respectively. Case basis credit reserves were $133,254 and $57,234 at December 31, 2004 and 2003, respectively. The case basis credit reserves at December 31, 2004 and 2003 were comprised of 11 and 10 credits with net par outstanding of $661,396 and $709,278, respectively. Additionally, we have reinsurance recoverables on case basis credit reserves of $16,499 and $2,535 at December 31, 2004 and 2003, respectively.

Ambac provides information on the classification of its loss reserve between active credit reserve and case basis credit reserve for the purpose of disclosing the components of the total reserve that relate to exposures that have not yet defaulted and those that have defaulted. The total reserve (active credit and case basis) was $254,055 and $189,414 at December 31, 2004 and 2003, respectively. The provision for losses and loss expenses in the accompanying Consolidated Statements of Operations represents the expense recorded to bring the total reserve to a level determined by management to be adequate for losses inherent in the non-derivative financial guaranty insurance portfolio.

Our liabilities for credit losses are based in part on the short-duration accounting guidance in Statement of Financial Accounting Standards (“SFAS”) No. 60, “Accounting and

Ambac Financial Group, Inc. and Subsidiaries    30

Notes to Consolidated Financial Statements

(Dollar Amounts in Thousands, Except Share Amounts)

Reporting by Insurance Enterprises.” The insured party has a right to a claim payment under the financial guaranty insurance policy at the date of the first scheduled debt service payment of a defaulted security. We believe a loss event occurs for financial guarantee insurance products at the time the issuers’ financial condition deteriorates to an impaired credit status rather than at the time the insured party has a right to a claim payment. Because of this belief and the ambiguities discussed below in the application of SFAS No. 60 to the financial guaranty industry, the Company does not believe that SFAS No. 60 alone provides sufficient guidance. As a result, the Company supplements the guidance in SFAS No. 60 with the guidance in SFAS No. 5, “Accounting for Contingencies,” which calls for a loss to be accrued if it is probable that a liability has been incurred at the date of the financial statements and the amount of loss can be reasonably estimated. The Company also relies by analogy on EITF Issue No. 85-20, “Recognition of fees for guaranteeing a loan,” which states that a guarantor should perform an ongoing assessment of the probability of loss to determine if a liability (and a loss) should be recognized under SFAS No. 5.

In management’s view, the accounting guidance noted above does not comprehensively address the attributes of financial guarantee insurance contracts, primarily due to the fact that SFAS No. 60 was developed prior to the maturity of the financial guarantee industry. Financial guarantee contracts have elements of long-duration insurance contacts in that they are irrevocable and extend over a period of time that may be 30 years or more but are considered and reported for regulatory purposes as property and casualty insurance, normally considered short-duration contracts. The short-duration and long-duration classifications have different methods of accounting for premium revenue, deferred acquisition costs and contract liability recognition.

The Company is aware that there are certain differences regarding the measurement of liabilities for credit losses among participants in the financial guaranty industry. Difficulties applying the existing insurance accounting literature such as the classification of the insurance contracts as either short-duration or long-duration to the attributes of financial guarantee insurance, different measurement models and assumptions utilized, regulatory guidance provided to certain entities, and the existence of accounting literature providing guidance with respect to liability recognition for loan guarantees are the reasons for differences among the industry participants.

In January and February of 2005, the Securities and Exchange Commission (“SEC”) staff discussed with financial guaranty industry participants differences in loss reserve recognition practices among those participants. Based on discussions with the SEC staff, Ambac understands the FASB staff is considering whether additional guidance regarding financial guarantee contracts should be provided. When and if the FASB or SEC reach a conclusion on this issue, the Company and the rest of the financial guaranty industry may be required to change some aspects of their loss reserving policies and the potential changes could extend to premium and expense recognition. The Company cannot predict how the FASB or SEC will resolve this issue and the resulting impact on our financial statements.

Until the issue is resolved, the Company intends to continue to apply its existing policy with respect to the establishment of both case and active credit reserves.

Obligations under Investment and Payment Agreements and Investment Repurchase Agreements: Obligations under investment and payment agreements and investment repurchase agreements are recorded as liabilities on the Consolidated Balance Sheets at the face value of the agreement. The carrying value of these obligations is adjusted for draws paid and interest credited to the account as well as any fair value hedge adjustments. These fair value hedge adjustments are discussed further in “Derivative Contracts used for Hedging Purposes” below. Unsettled agreements are recorded on a trade-date basis on the Consolidated Balance Sheets at the time of commitment. Interest expense is computed based upon daily outstanding settled liability balances at rates and periods specified in the agreements.

Net Premiums Earned: Up-front insurance premiums written are received for an entire bond issue. A bond issue may contain several maturities. The premium is allocated to each bond maturity proportionally, based on total principal amount guaranteed and is recognized on a straight-line basis over the term of each maturity. Installment insurance premiums written are recognized over each installment period. When an issue insured by Ambac Assurance has been refunded or called, the remaining unrecognized premium (net of refunding credits, if any) is recognized at that time.

Financial Services Revenue: Ambac’s Financial Services revenues includes the following products:

Investment agreements—Ambac provides investment agreements and investment repurchase agreements principally to asset-backed and structured finance issuers, states, municipalities and municipal authorities, whereby Ambac agrees to pay an agreed-upon return based on funds deposited. Proceeds from these investment agreement and investment repurchase agreement obligations are used to invest in high credit quality fixed income investments. Interest income from these investments is included in Financial Services revenues.

Interest rate swaps and total return swaps—Ambac provides interest rate swaps principally to states, municipalities and municipal authorities in connection with their financings. Ambac also enters into total return swaps with various financial institutions. All interest rate swaps and total return swap revenues are accounted for as “Derivative Contracts Classified as Held for Trading Purposes,” which is discussed in the Derivatives Contracts section below.

Derivative Contracts: All derivative instruments are recognized in the Consolidated Balance Sheets as either assets or liabilities depending on the rights or obligations under the contracts. All derivative instruments are measured at estimated fair value. When available, quotes are obtained from independent market sources. However, when quotes are not available, Ambac uses internally developed valuation models. These valuation models require market-driven inputs, including contractual

31    Ambac Financial Group, Inc. and Subsidiaries

terms, credit spreads on underlying referenced obligations, yield curves and tax-exempt interest ratios. The valuation results from these models could differ materially from amounts that would actually be realized in the market. At the inception of a derivative contract (day one), we value the contract at the model value if we can verify all of the significant model inputs to observable market data. Where we cannot verify all of the significant model inputs to observable market data, we value the contract at the transaction price at inception and, consequently, record no gain or loss in accordance with EITF Issue No. 02-3, “Issues Involved in Accounting for Derivative Contracts Held for Trading Purposes and Contracts Involved in Energy Trading and Risk Management Activities.”

All derivative contracts used for hedging purposes and classified as held for trading purposes are recorded on the Consolidated Balance Sheets on a gross basis; assets and liabilities are netted by customer only when a legal right of set-off exists. Gross asset and gross liability balances for all derivatives are recorded as Derivative Assets or Derivative Liabilities on the Consolidated Balance Sheets.

Derivative Contracts used for Hedging Purposes: Interest rate and currency swaps are utilized to hedge exposure to changes in fair value of assets or liabilities resulting from changes in interest rates and foreign exchange rates, respectively. These interest rate and currency swap hedges are referred to as “fair value” hedges. Gains and losses on fair value hedges are recognized currently in net income. The gain or loss on the hedged asset or liability attributable to the hedged risk (interest rate or foreign exchange risk) adjusts the carrying amount of the hedged item and is recognized currently in net income. If the fair value hedge is fully effective, the gain or loss on the interest rate or currency swap will exactly offset the gain or loss on the hedged item. If exact offset is not achieved, the difference would be the effect of hedge ineffectiveness, which is recognized currently in net income. During 2004, 2003 and 2002, the net amount of hedge ineffectiveness reported in “Net mark-to-market gains (losses) on derivative hedge contracts” in the Consolidated Statements of Operations was $80, $792 and $(1,020), respectively.

Interest rate swaps are also utilized to hedge the exposure to variable interest rates. These interest rate swap hedges are referred to as “cash flow” hedges. Gains and losses on interest rate swaps designated as cash flow hedges are reported in “Accumulated Other Comprehensive Income” in stockholders’ equity, until earnings are affected by the variability in cash flows of the designated hedged item. During 2004, 2003 and 2002, there was no hedge ineffectiveness reported in net income for cash flow hedges.

Ambac discontinues hedge accounting prospectively when it is determined that the derivative is no longer effective in offsetting changes in the fair value or cash flows of the hedged item, the derivative expires, is sold or terminated. When hedge accounting is discontinued because it is determined that the derivative no longer qualifies as an effective fair value hedge, Ambac continues to carry the derivative on the balance sheet at its fair value, and no longer adjusts the hedged asset or liability for changes in fair value. The adjustment of the carrying amount of the hedged asset or liability is accounted for in the same manner as other components of the carrying amount of that asset or liability. When hedge accounting is discontinued because it is determined that the derivative no longer qualifies as an effective cash flow hedge, Ambac continues to carry the derivative on the balance sheet at its fair value. The net derivative gain or loss related to a discontinued cash flow hedge (recognized during the period of hedge effectiveness) will continue to be reported in Accumulated Other Comprehensive Income and amortized into net income as a yield adjustment to the previously designated asset or liability. If the previously designated asset or liability is sold or matures, the net derivative gain or loss related to a discontinued cash flow hedge reported in Accumulated Other Comprehensive Income will be reclassified into net income immediately. All subsequent changes in fair values of derivatives previously designated as cash flow hedges will be recognized currently in net income. As of December 31, 2004, $175 of deferred losses on derivative instruments reported in Accumulated Other Comprehensive Income are expected to be reclassified to net income during the next twelve months. Transactions and events expected to occur over the next twelve months that will necessitate reclassifying these derivative losses include the repricing of a variable-rate investment agreement.

Derivative Contracts Classified as Held for Trading Purposes:

Credit Derivatives: Ambac, through its subsidiary Ambac Credit Products, enters into structured credit derivative transactions with various financial institutions. Management views these structured credit derivative transactions as an extension of its financial guarantee business, which the Company intends to hold for the entire term of the contract. These structured credit derivative contracts are accounted for at fair value since they do not qualify for the financial guarantee scope exception under SFAS 133, as amended. Changes in fair value are recorded in the Consolidated Statement of Operations. The fee component is reflected in “Other Credit Enhancement Fees” and the mark-to-market gains or losses associated with credit spread changes is reflected in “Net Mark-to-Market Gains (Losses) on Credit Derivative Contracts.”

Financial Services: Ambac, through its subsidiary Ambac Financial Services, provides interest rate swaps to states, municipalities and their authorities, and other entities in connection with their financings. Ambac Capital Services enters into total return swaps with professional counterparties. Total return swaps are primarily used for fixed income obligations, which meet Ambac Assurance’s credit underwriting criteria. These contracts are recorded on trade date at fair value. Changes in fair value are recorded as a component of “Derivative Product Revenues” in the accompanying Consolidated Statements of Operations.

Depreciation and Amortization: Depreciation of furniture and fixtures and electronic data processing equipment is charged over the estimated useful lives of the respective assets, ranging from three to five years, using the straight-line method. Amortization of leasehold improvements is charged over the lesser of ten years or the remaining term of the operating leases, ranging from four to ten years, using the straight-line method.

Postretirement and Postemployment Benefits: Ambac provides various postretirement and postemployment benefits, including pension and health and life benefits covering substantially all employees who meet certain age and service

Ambac Financial Group, Inc. and Subsidiaries    32

Notes to Consolidated Financial Statements

(Dollar Amounts in Thousands, Except Share Amounts)

requirements. Ambac accounts for these benefits under the accrual method of accounting. Amounts related to the defined benefit pension plan and postretirement health benefits are charged based on actuarial determinations.

Stock Compensation Plans: Effective January 1, 2003, Ambac began to account for stock-based employee compensation in accordance with the fair-value method prescribed by SFAS Statement 123, “Accounting for Stock-Based Compensation,” (“SFAS 123”) as amended by SFAS Statement 148, “Accounting for Stock-Based Compensation—Transition and Disclosure,” (“SFAS 148”), prospectively to all employee awards granted after January 1, 2003. Under this method of adoption, compensation expense is recognized over the relevant service period based on the fair value of stock options and restricted stock units granted for 2003 and future years. No unearned compensation is included in “Stockholders’ Equity” for such stock options and restricted stock units granted. Rather, such stock options and restricted stock units are included in “Stockholders’ Equity” under SFAS 123 when services required from employees in exchange for the awards are rendered and expensed.

Compensation expense resulting from stock options and restricted stock units granted for the years ended December 31, 2002 and prior years is accounted for under the intrinsic-value based method prescribed by APB Opinion No. 25, “Accounting for Stock Issued to Employees,” as permitted by SFAS 123. Therefore, no compensation expense was recognized for stock options issued for years prior to 2003 that had no intrinsic value on the date of grant. Compensation expense for restricted stock units issued for the years prior to 2003 was, and continues to be, recognized over the relevant service periods using amortization schedules based on the applicable vesting provisions.

If Ambac were to recognize compensation expense over the relevant service period under the fair-value method of SFAS 123 with respect to stock options granted for the year ended December 31, 2002 and all prior years, net earnings would have decreased, resulting in pro forma net earnings and EPS as presented below:

	2004			2003			2002
Net income, as reported	$	724,551		$	618,915		$	432,594
Add: Stock-based employee compensation included in reported net income, net of tax		6,284			4,530			—
Deduct: Total stock-based employee compensation determined under the fair value based method for all awards, net of tax		(13,745	)		(15,535	)		(12,599	)
Pro forma net income	$	717,090		$	607,910		$	419,995
Earnings per share:
As reported	$	6.61		$	5.81		$	4.08
Pro-forma	$	6.54		$	5.71		$	3.96
Earnings per diluted share:
As reported	$	6.53		$	5.66		$	3.97
Pro-forma	$	6.47		$	5.56		$	3.85

Foreign Currency: Financial statement accounts expressed in foreign currencies are translated into U.S. dollars in accordance with SFAS Statement 52, “Foreign Currency Translation” (“SFAS 52”). Under SFAS 52, functional currency assets and liabilities are translated into U.S. dollars using exchange rates in effect at the balance sheet dates and the related translation adjustments are included as a component of “Accumulated Other Comprehensive Income,” net of any related taxes in Stockholders’ Equity. Functional currencies are generally the currencies of the local operating environment. Income statement accounts expressed in functional currencies are translated using average exchange rates. Foreign currency transaction gains and losses, arising primarily from sales of long-term foreign denominated investment securities, short-term investment securities and cash denominated in foreign currencies, are reflected in net income. The Consolidated Statements of Operations include pre-tax gains from such foreign exchange items of $6,600, $10,027 and $1,904 for 2004, 2003 and 2002, respectively.

Income Taxes: Ambac files a consolidated Federal income tax return with its subsidiaries. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in the period that includes the enactment date.

Special Purpose and Variable Interest Entities: In January 2003, the FASB released FASB Interpretation No. 46 “Consolidation of Variable Interest Entities” (“FIN 46”). In December 2003, the FASB released a revision of FIN 46 (“FIN 46-R”), which includes substantial changes from the original FIN 46. FIN 46 and FIN 46-R provide accounting and disclosure rules for determining whether certain entities should be consolidated in Ambac’s consolidated financial statements. An entity is subject to FIN 46 and FIN 46-R, and is called a Variable Interest Entity (“VIE”), if it has (i) equity that is insufficient to permit the entity to finance its activities without additional subordinated financial support or (ii) equity investors that cannot make significant decisions about the entity’s operations or that do not absorb the majority of expected losses or receive the majority of expected residual returns of the entity. A VIE is consolidated by its primary beneficiary, which is the party that has a majority of the expected losses or a majority of the expected residual returns of the VIE or both. FIN 46 requires disclosures for companies that have either a primary or significant variable interest in a VIE. All other entities not considered VIEs are evaluated for consolidation under SFAS No. 94, “Consolidation of all Majority-Owned Subsidiaries.” Ambac adopted FIN 46-R as of December 31, 2003. See Note 10 for a further discussion of the impact of Special Purpose Entities and VIEs on Ambac’s financial statements.

33    Ambac Financial Group, Inc. and Subsidiaries

Net Income Per Share: Basic net income per share is computed by dividing net income available to common stockholders by the weighted-average number of common shares outstanding during the year. Common shares outstanding includes common stock and restricted stock units for which no future service is required as a condition to the delivery of the underlying common stock. Diluted net income per share represents the per share allocation of net income attributable to common stockholders based on the weighted-average average number of common shares actually outstanding, plus all dilutive potential common shares outstanding during the year. All dilutive potential common shares outstanding includes common stock deliverable pursuant to stock options and restricted stock units. These dilutive shares totaled 2,516,877, 2,856,673 and 3,114,443 additional shares from the assumed conversion of dilutive stock options and restricted stock units at December 31, 2004, 2003 and 2002, respectively. The number of additional shares is calculated by assuming that outstanding stock options were exercised and that the proceeds from such exercises were used to acquire shares of common stock at the average market price during the year.

Accounting Standards: In December 2004, the FASB issued SFAS 123-R, “Share-Based Payment.” This Statement is a revision of SFAS 123, “Accounting for Stock-Based Compensation” and supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees,” and its related implementation guidance. SFAS 123-R requires entities to recognize compensation cost for all equity-classified awards after the effective date using the fair-value measurement method. SFAS 123-R is effective for interim or annual periods beginning after June 15, 2005. Ambac will adopt SFAS 123-R on July 1, 2005 by using a modified prospective approach. The adoption of SFAS 123-R is not expected to have a material impact on Ambac’s operating results. Ambac continues to evaluate other aspects of adopting SFAS 123-R.

On September 30, 2004, the FASB voted unanimously to delay the effective date of certain provisions in EITF 03-1, “The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments.” The delay applies to both debt and equity securities and specifically applies to impairments caused by changes in interest rate and credit spreads. In addition, the provisions of EITF 03-1 that have been delayed relate to the requirements that a company declare its intent to hold the security to recovery and designate a recovery period in order to avoid recognizing an other-than-temporary impairment charge through earnings. The FASB will be issuing implementation guidance related to this topic. Once issued, Ambac will evaluate the impact of adopting EITF 03-1. The disclosures required by EITF 03-1 are included in Note 3 to the consolidated financial statements.

In May 2004, the FASB issued FASB Staff Position FAS 106-2, “Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003” (“FSP FAS 106-2”), which superceded FSP FAS 106-1, in response to the December 2003 enactment of the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (“the Act”). The Act introduces a prescription drug benefit for individuals under Medicare (Medicare Part D) as well as a federal subsidy equal to 28% of prescription drug claims for sponsors of retiree health care plans with drug benefits that are at least actuarially equivalent to those to be offered under Medicare Part D. If a plan is determined to be actuarially equivalent to Medicare Part D, FSP FAS 106-2 requires plan sponsors to disclose the effect of the subsidy on the net periodic expense and the accumulated postretirement benefit obligation in their interim and annual financial statements for periods beginning after June 15, 2004. Plan sponsors who initially elected to defer accounting for the effects of the subsidy are allowed the option of retroactive application to the date of enactment or prospective application from the date of adoption. Under FSP FAS 106-1, Ambac elected to defer the accounting for the effects of the Act. However, Ambac believes that our plans are eligible for the subsidy and decided to adopt FSP FAS 106-2 in the third quarter of 2004 retroactive to January 1, 2004. The adoption of FSP FAS 106-2 did not have a material effect on Ambac’s operating results.

Reclassifications: Certain reclassifications have been made to prior years’ amounts to conform to the current year’s presentation.

Ambac Financial Group, Inc. and Subsidiaries    34

Notes to Consolidated Financial Statements

(Dollar Amounts in Thousands, Except Share Amounts)

3 INVESTMENTS

The amortized cost and estimated fair value of investments at December 31, 2004 and 2003 were as follows:

	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Estimated Fair Value
2004:
Fixed income securities:
Municipal obligations	$	6,017,682	$	341,903	$	7,395	$	6,352,190
Corporate obligations		632,303		45,238		3,758		673,783
Foreign obligations		217,007		21,282		416		237,873
U.S. government obligations		123,499		1,923		101		125,321
U.S. agency obligations		829,886		50,666		4,310		876,242
Mortgage and asset-backed securities		5,605,098		42,471		11,760		5,635,809
Short-term		521,226		—		—		521,226
Other		3,731		773		270		4,234
		13,950,432		504,256		28,010		14,426,678
Fixed income securities pledged as collateral:
Mortgage and asset-backed securities		345,195		209		3,662		341,742
Total	$	14,295,627	$	504,465	$	31,672	$	14,768,420
2003:
Fixed income securities:
Municipal obligations	$	5,404,013	$	336,424	$	6,391	$	5,734,046
Corporate obligations		1,029,950		62,655		6,374		1,086,231
Foreign obligations		156,901		20,942		664		177,179
U.S. government obligations		88,894		1,407		351		89,950
U.S. agency obligations		624,331		28,391		5,070		647,652
Mortgage and asset-backed securities		5,288,309		38,590		12,738		5,314,161
Short-term		250,382		—		—		250,382
Other		4,528		315		426		4,417
		12,847,308		488,724		32,014		13,304,018
Fixed income securities pledged as collateral:
U.S. government obligations		12,209		53		—		12,262
Mortgage and asset-backed securities		649,837		3,497		4,174		649,160
		662,046		3,550		4,174		661,422
Total	$	13,509,354	$	492,274	$	36,188	$	13,965,440

Foreign obligations consist primarily of government issued securities which are denominated in either Pounds sterling, Euros or Australian dollars.

The amortized cost and estimated fair value of fixed income securities and short-term investments at December 31, 2004, by contractual maturity, were as follows:

	Amortized Cost		Estimated Fair Value
Due in one year or less	$	596,739	$	606,506
Due after one year through five years		1,023,984		1,055,447
Due after five years through ten years		1,768,158		1,832,337
Due after ten years		4,956,453		5,296,579
		8,345,334		8,790,869
Mortgage and asset-backed securities		5,950,293		5,977,551
	$	14,295,627	$	14,768,420

Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.

35    Ambac Financial Group, Inc. and Subsidiaries

At December 31, 2004, the cost of 196 investments in fixed income securities exceeded their fair value by $31,672. There were no individual securities with material unrealized losses as of December 31, 2004 and 2003. The following table shows gross unrealized losses and fair values of Ambac’s investments, aggregated by investment category and length of time that the individual securities have been in a continuous unrealized loss position, at December 31, 2004 and 2003:

	Less Than 12 Months				12 Months or More				Total
Temporarily Impaired Securities	Fair Value		Gross Unrealized Loss		Fair Value		Gross Unrealized Loss		Fair Value		Gross Unrealized Loss
2004:
Municipal obligations	$	409,651	$	4,586	$	124,564	$	2,809	$	534,215	$	7,395
Corporate obligations		58,082		588		33,754		3,170		91,836		3,758
Foreign obligations		8,516		13		56,995		403		65,511		416
U.S. government obligations		24,701		101		—		—		24,701		101
U.S. agency obligations		261,340		2,717		29,916		1,593		291,256		4,310
Mortgage and asset-backed securities		1,040,614		7,033		613,678		8,389		1,654,292		15,422
Other		151		3		852		267		1,003		270
Total temporarily impaired securities	$	1,803,055	$	15,041	$	859,759	$	16,631	$	2,662,814	$	31,672
2003:
Municipal obligations	$	433,907	$	5,958	$	6,509	$	433	$	440,416	$	6,391
Corporate obligations		100,569		1,801		100,858		4,573		201,427		6,374
Foreign obligations		36,557		664		—		—		36,557		664
U.S. government obligations		50,210		351		—		—		50,210		351
U.S. agency obligations		308,446		5,070		—		—		308,446		5,070
Mortgage and asset-backed securities		1,277,315		15,184		165,998		1,728		1,443,313		16,912
Other		146		7		1,514		419		1,660		426
Total temporarily impaired securities	$	2,207,150	$	29,035	$	274,879	$	7,153	$	2,482,029	$	36,188

Of the $15,041 and $29,035 that have been in a gross unrealized loss position for less than a year, 100% and 99% are rated investment grade for 2004 and 2003, respectively. Of the $16,631 and $7,153 that have been in a gross unrealized loss position for a year or more, 98% are rated investment grade for 2004 and 2003. The unrealized loss on these securities reflects the current interest rate environment.

Management has determined that the unrealized losses on Ambac’s investments in fixed income securities at December 31, 2004 are temporary in nature. Ambac conducts a review each quarter to identify and evaluate investments that have indications of possible impairment. An investment in a debt security is impaired if its fair value falls below its cost and the decline is considered “other than temporary.” Factors considered when assessing impairment include: (i) securities whose fair values have declined by 20% or more below amortized cost; (ii) securities whose market values have declined by 5% or more below amortized cost for a continuous period of at least six months; (iii) recent downgrades by rating agencies; (iv) the financial condition of the issuer; (v) whether scheduled interest payments are past due; and (vi) whether Ambac has the ability and intent to hold the security for a sufficient period of time to allow for anticipated recoveries in fair value.

If we believe a decline in the value of a particular investment is temporary, we record the decline as an unrealized loss in Accumulated Other Comprehensive Income in Stockholders’ Equity, net of income tax, on our Consolidated Balance Sheets. If we believe the decline is “other than temporary,” we write down the carrying value of the investment and record a loss on our Consolidated Statements of Operations. Ambac’s assessment of a decline in value includes management’s current judgment of the factors noted above. If that judgment changes in the future, Ambac may ultimately record a loss after having originally concluded that the decline in value was temporary.

Securities carried at $6,644 and $6,959 at December 31, 2004 and 2003, respectively, were deposited by Ambac with governmental authorities or designated custodian banks as required by laws affecting insurance companies.

Net investment income from the Financial Guarantee segment was comprised of the following:

	2004			2003			2002
Fixed income securities	$	361,864		$	322,098		$	297,741
Short-term investments		2,465			2,321			2,831
Loans		1,638			—			—
Total investment income		365,967			324,419			300,572
Investment expense		(4,881	)		(3,330	)		(3,275	)
Net investment income	$	361,086		$	321,089		$	297,297

The Financial Guarantee segment had gross realized gains of $46,627, $45,890 and $48,529 in 2004, 2003 and 2002, respectively, and gross realized losses of $16,623, $5,700 and $7,611 in 2004, 2003 and 2002, respectively. Included in the above is net foreign exchange gains of $5,654, $8,528 and $1,850 in 2004, 2003 and 2002, respectively. Net foreign exchange gains primarily resulted from sales of long-term foreign currency denominated securities in 2004 and 2003 and investments in short-term foreign currency denominated securities in 2002.

The Financial Services segment had gross realized gains of $11,217, $18,885 and $10,313 in 2004, 2003 and 2002, respectively, and gross realized losses of $4,129, $20,866 and $144,520 in 2004, 2003 and 2002, respectively. Included in 2003 and 2002 realized losses was an impairment write-down of $10,470 and $139,731, respectively, to the carrying value of asset-backed notes issued by National Century Financial Enterprises, Inc. (“NCFE”). These notes, which were rated triple-A until October 25, 2002, have defaulted and NCFE filed for protection under Chapter 11 of the U.S. Bankruptcy Code in November of 2002. The NCFE securities, which are

Ambac Financial Group, Inc. and Subsidiaries    36

Notes to Consolidated Financial Statements

(Dollar Amounts in Thousands, Except Share Amounts)

backed by health care receivables, have been written down to approximately 14% of par value at December 31, 2003. As of December 31, 2004 NCFE is valued at 4% of par value due to cash received from the distribution of assets in the trust by the bankruptcy trustee. This value represents Ambac’s best estimate of its future recovery from assets in the trust based on existing facts and circumstances and presumes no recovery from litigation. This loss was specific to the NCFE notes and had no impact on other investments held. There were no impairment write-downs during 2004.

Ambac routinely pledges and receives collateral related to certain business lines and/or transactions. The following is a description of those arrangements by collateral source:

(1) Securities purchased under agreements to resell (repurchase agreements)—In the normal course of business, Ambac holds securities under repurchase agreements with various counter-parties. A portion of these securities has been pledged to Ambac’s investment agreement counterparties (including counterparties with agreements structured as investment repurchase agreements). Such securities may not then be repledged by the investment agreement counterparty to another entity. Securities purchased under agreements to resell have also been pledged to certain interest rate swap and structured credit derivative counterparties. Under the terms of these derivative agreements, Ambac and its counterparties may be required to pledge collateral to the other resulting from changes in the estimated fair value of those agreements. Both Ambac and the counterparties have identical rights to pledge or rehypothecate the securities received under these derivative agreements.

(2) Securities held in Ambac’s investment portfolio—Ambac pledges investments it holds in its Financial Services investment portfolio to both investment and payment agreement counterparties and derivative counterparties in accordance with the terms and conditions described in (1) above. Ambac has also sold securities in its Financial Services investment portfolio under agreements to repurchase (reverse repurchase agreements). Ambac’s counterparties under derivative agreements and reverse repurchase agreements have the right to pledge or rehypothecate the securities, which were pledged or sold, respectively. Consequently, securities held in Ambac’s investment portfolio which are pledged or sold under reverse repurchase and derivative agreements, respectively, are separately classified on the Consolidated Balance Sheet as “Fixed income securities pledged as collateral, at fair value.”

(3) Cash and Securities pledged to Ambac under derivative agreements—Ambac may repledge securities it holds from certain derivative counterparties as described in (1) above, to other derivative counterparties in accordance with its rights and obligations under those agreements.

The following table presents (i) the sources of collateral either received from various counterparties where Ambac is permitted to sell or re-pledge or directly held in the investment portfolio, and (ii) how that collateral was pledged to various investment and payment agreement, derivative and reverse repurchase agreement counterparties at December 31, 2004 and 2003:

	Collateral Pledged
	Fair Value of Cash and Underlying Securities		Fair Value of Securities Pledged to Investment and Payment Agreement Counterparties		Fair Value of Cash and Securities Pledged to Derivative Counterparties		Fair Value of Securities Sold Under Agreements to Repurchase
2004:
Sources of Collateral:
Securities purchased under agreements to resell	$	699,415	$	439,573	$	14,199	$	—
Securities pledged directly from the investment portfolio		726,213		384,471		—		341,742
Cash and securities pledged from its derivative counterparties		153,143		—		109,044		—
2003:
Sources of Collateral:
Securities purchased under agreements to resell	$	421,904	$	322,887	$	86,197	$	—
Securities pledged directly from the investment portfolio		2,963,653		2,302,231		52,558		608,864
Cash and securities pledged from its derivative counterparties		151,539		—		97,586		—

37    Ambac Financial Group, Inc. and Subsidiaries

4 LOANS

In the normal course of business, Ambac primarily extended loans for the following purposes:

Structured Municipal Transactions: Loans have been extended to customers participating in certain structured municipal transactions. The loans are collateralized with cash in amounts adequate to repay the loan balance. Equipment and other assets underlying the transactions serve as additional collateral for the loans. Ambac acts as the payment custodian and holds the funds posted as collateral. At December 31, 2004 and 2003, the loan balances outstanding and collateral held were $648,631 and $672,200, respectively. As of December 31, 2004 and 2003, the interest rates on these loans ranged from 6.25% to 8.06% and from 6.25% to 8.42%, respectively. The range of expected final maturity dates of these loans is January 2013 to January 2027 as of December 31, 2004.

Project Financing: Ambac has purchased loans which finance an infrastructure project that are secured by the assets underlying the project. As of December 31, 2004, Ambac has sold these loans at a realized loss of $1,989. As of December 31, 2003, Ambac had outstanding loan balances of $159,644 with interest rates ranging from 3.39% to 5.18%. The range of expected maturity dates of these loans is July 2014 to July 2019 as of December 31, 2003.

Investment Partnerships: Ambac has senior secured short-term loans outstanding to certain investment partnerships which invest in diversified portfolios of assets, primarily high-yield debt obligations and bank loans. The loans are collateralized with a first priority lien and security interest in the invested assets. As of December 31, 2004, Ambac had outstanding loan balances of $21,478 with interest rates ranging from 3.07% to 3.34%. The range of maturity dates for these loans was February 2005 to April 2005. As of December 31, 2003, Ambac had outstanding loan balances of $6,137 with interest rates ranging from 2.25% to 2.28%. The range of maturity dates for these loans was January 2004 to February 2004.

Refer to Note 10 for additional information on loans issued by entities consolidated under the provisions of FIN 46.

5 REINSURANCE

In the ordinary course of business, Ambac Assurance cedes exposures under various reinsurance contracts primarily designed to minimize losses from large risks and to protect capital and surplus. The effect of reinsurance on premiums written and earned was as follows:

Years Ended December 31,	2004						2003						2002
	Written			Earned			Written			Earned			Written			Earned
Direct	$	1,009,243		$	777,677		$	1,114,445		$	692,170		$	871,070		$	515,119
Assumed		38,568			38,059			29,258			36,958			32,962			41,486
Ceded		(70,946	)		(99,077	)		(138,146	)		(108,811	)		(113,542	)		(85,071	)
Net premiums	$	976,865		$	716,659		$	1,005,557		$	620,317		$	790,490		$	471,534

The reinsurance of risk does not relieve Ambac Assurance of its original liability to its policyholders. In the event that any of Ambac Assurance’s reinsurers are unable to meet their obligations under reinsurance contracts, Ambac Assurance would, nonetheless, be liable to its policyholders in the full amount of its policy.

Ambac Assurance’s reinsurance assets, including prepaid reinsurance and reinsurance recoverables on losses amounted to $314,095 at December 31, 2004. This credit exposure existed at December 31, 2004 with respect to reinsurance recoverables to the extent that any reinsurer may not be able to reimburse Ambac Assurance under the terms of these reinsurance arrangements. At December 31, 2004, approximately 30% of the reinsurance assets were due from unauthorized reinsurers. In order to obtain statutory recognition, all of these amounts were collateralized ($214,525 of collateral at December 31, 2004). The collateral can be drawn on for amounts that remain unpaid beyond specified time periods on an individual reinsurer basis. The remaining 70% of the reinsurance assets were from authorized reinsurers. The terms authorized and unauthorized pertain to regulatory categories, not credit worthiness. Approximately 85% of the balances with respect to authorized reinsurers are from reinsurers rated AA or better, as rated by Standard and Poor’s. This rating is a measure of financial strength.

To minimize exposure to significant losses from reinsurers, Ambac Assurance (i) monitors the financial condition of its reinsurers; (ii) has collateral provisions in certain reinsurance contracts; and (iii) has certain termination triggers that can be exercised by Ambac Assurance in the event of a rating downgrade of a reinsurer. For the years ended December 31, 2004, 2003 and 2002, reinsurance recoveries, which reduced loss and loss expenses incurred, amounted to $2,581, $4,041 and $1,334, respectively. Reinsurance recoverables on paid losses and loss expenses as of December 31, 2004 and 2003 were $266 and $495, respectively. Ambac Assurance pledged cash and fixed income securities to foreign insurers of $15,086 and $13,584 at December 31, 2004 and 2003, respectively, related to business assumed from those insurers.

Ambac Financial Group, Inc. and Subsidiaries    38

Notes to Consolidated Financial Statements

(Dollar Amounts in Thousands, Except Share Amounts)

6 LOSSES AND LOSS EXPENSE RESERVE

As discussed in Note 2, Ambac Assurance’s liability for losses and loss expenses consists of case basis and active credit reserves. Following is a summary of the activity in the case basis credit and active credit reserve accounts and the components of the liability for loss and loss expense reserves:

	2004			2003			2002
Case basis loss and loss expense reserves:
Balance at January 1	$	57,233		$	53,592		$	24,384
Less: reinsurance recoverables		2,535			4,600			1,021
Net balance at January 1		54,698			48,992			23,363
Transfers from active credit reserves:
Current year		40,215			25,361			36,365
Prior years		40,765			14,403			(1,480	)
Total transfers from active credit reserves		80,980			39,764			34,885
Paid (net of recoveries) related to:
Current year		214			9,825			5,740
Prior years		18,709			24,233			3,516
Total paid		18,923			34,058			9,256
Net balance at December 31		116,755			54,698			48,992
Plus reinsurance recoverables		16,499			2,535			4,600
Balance at December 31		133,254			57,233			53,592
Active credit reserve:
Balance at January 1		132,181			118,545			126,730
Provision for losses		69,600			53,400			26,700
Transfers to case reserves		(80,980	)		(39,764	)		(34,885	)
Balance at December 31		120,801			132,181			118,545
Total	$	254,055		$	189,414		$	172,137

During 2004, 2003 and 2002, gross losses paid were $55,321, $45,621 and $11,143, respectively. During 2004, 2003 and 2002, recoveries from reinsurers for paid losses were $2,769, $4,041 and $1,334, respectively. During 2004, 2003 and 2002, other recoveries of losses were $33,628, $7,522 and $553, respectively.

The provision for losses and loss expenses represents the expense recorded to bring the total reserve (active credit and case basis credit) to a level determined by management to be adequate for losses inherent in the non-derivative financial guaranty insurance portfolio as of the reporting date. The provision for losses of $69,600 is the amount recorded as loss and loss expenses in the Consolidated Statements of Operations. Provisions are recognized through the active credit reserve based on the ongoing analysis of the portfolio as discussed in Note 2. Upon default of the underlying credit, the reserve is transferred from active credit reserves to case basis credit reserves. Additional provisions for losses upon further credit deterioration of a defaulted exposure are initially recorded in active credit reserve and subsequently transferred to case basis credit reserve. The 2004 provision for losses was primarily impacted by two credits. The first credit is a domestic health care institution, which defaulted in a prior year and continues to experience significant financial stress. Ambac’s gross exposure to this credit amounts to approximately $73,000 at December 31, 2004. There is no reinsurance for this exposure. At December 31, 2004, $40,000 of case basis credit reserves were held for this health care exposure. During 2004, $25,000 of additional provision for losses was recorded for this transaction based on our analysis of deteriorating financial information. Ambac is closely surveilling the credit and is in frequent communication with management. Ambac believes the primary factor causing the loss on this exposure is the competitive local environment for health care delivery and the resulting impact on revenue generation. The second credit is an enhanced equipment trust certificate (“EETC”) securitization. This transaction is secured by seven commercial aircraft, including the lease income generated by leases of the aircraft to a commercial airline. During 2004, the airline leasing the aircraft filed for bankruptcy and defaulted on its lease obligations. Ambac insured the most senior debt layer of the transaction and has gross exposure to this transaction of approximately $174,000. The exposure net of reinsurance is approximately $127,000. At December 31, 2004, approximately $55,000 of gross case reserves were held for this EETC exposure ($40,000, net of reinsurance). Provision for losses of $40,000 was recorded during 2004 to reflect the deterioration of this exposure. A reduction of any of the outstanding exposure is entirely dependent upon the value of the aircraft collateral underlying the transaction. Ambac is entitled to direct that the aircraft be sold outright or leased and the related proceeds would be used to reduce the exposure outstanding. Aircraft valuations have declined sharply over recent years. Management believes the primary factor that has adversely impacted collateral values is the severely distressed financial condition of the airline industry. The airline industry has been adversely impacted by several factors including the September 11 terror attacks on the United States and the related adverse impact it had on passenger demand. Other important factors adversely impacting the airline industry include high fuel costs and intense price competition.

7 LONG-TERM DEBT AND LINES OF CREDIT

Long-term Debt: The carrying value of long-term debt was as follows:

As of December 31,	2004		2003
9 3/8% Debentures, due 2011	$	142,219	$	142,176
7 1/2% Debentures, due 2023		74,620		74,599
7.00% Debentures, due 2051		200,000		200,000
5.95% Debentures, due 2103		200,000		200,000
5.875% Debentures, due 2103		175,000		175,000
Total Debentures		791,839		791,775
Variable interest entity notes		1,074,368		189,151
Total long-term debt	$	1,866,207	$	980,926

The debentures due on August 1, 2011 were issued on August 8, 1991 in the principal amount of $150,000 and bear interest of 9 ³/8%, payable on February 1 and August 1 of each year and are non-callable. In July 2001, Ambac extinguished $7,500, thereby reducing the principal amount of the debt to $142,500.

39    Ambac Financial Group, Inc. and Subsidiaries

The debentures due on May 1, 2023 were issued on May 11, 1993 in the principal amount of $75,000 and bear interest of 7¹/₂%, payable on May 1 and November 1 of each year and are non-callable.

The debentures due on October 17, 2051 were issued on October 18, 2001 in the principal amount of $200,000 and bear interest of 7.00%, payable on March 31, June 30, September 30 and December 31 of each year. The debentures may not be redeemed prior to October 17, 2006 and were sold at 100% of their principal amount. On or after October 17, 2006, Ambac may redeem the debentures, in whole at any time or in part from time to time, at 100% of their principal amount, plus accrued interest to the date of redemption.

The debentures due on February 28, 2103 were issued on February 28, 2003 in the principal amount of $200,000 and bear interest of 5.95%, payable on March 31, June 30, September 30 and December 31 of each year. The debentures may not be redeemed prior to February 28, 2008. On or after February 28, 2008, Ambac may redeem the debentures at 100% of their principal amount, plus accrued interest to the date of redemption. Ambac may also shorten the maturity of the debentures or redeem all of the debentures at 100% of their principal amount, plus accrued interest, in the event of certain changes involving United States federal income taxation.

The debentures due on March 24, 2103 were issued on March 24, 2003 in the principal amount of $175,000 and bear interest of 5.875%, payable on March 31, June 30, September 30 and December 31 of each year beginning June 30, 2003. The debentures may not be redeemed prior to March 24, 2008. On or after March 24, 2008, Ambac may redeem the debentures at 100% of their principal amount, plus accrued interest to the date of redemption. Ambac may also shorten the maturity of the debentures or redeem all of the debentures at 100% of their principal amount, plus accrued interest, in the event of certain changes involving United States federal income taxation.

The variable interest entity notes were issued by consolidated VIEs. Ambac is the primary beneficiary of these VIEs as a result of providing financial guarantees on the variable interest notes. Consequently, Ambac has consolidated these variable interest entity notes and all other assets and liabilities of these VIEs. Ambac is not primarily liable for the debt obligations of these entities. Ambac would only be required to make these payments on these debt obligations in the event that the issuer defaults on any principal or interest due. Ambac’s creditors do not have rights with regard to the assets of these VIEs. Please refer to Note 10 for a detailed description of the variable interest entity notes.

Credit Facilities: Ambac and Ambac Assurance have a revolving credit facility with six major international banks for $300,000, which expires in July 2005 and provides a two-year term loan provision. The facility is available for general corporate purposes, including the payment of claims. As of December 31, 2004, no amounts were outstanding under this credit facility. This facility’s financial covenants require that Ambac: (i) maintain as of the end of each fiscal quarter a debt to capital ratio of not more than 30% and (ii) maintain at all times total stockholders’ equity equal to or greater than $2.0 billion. At December 31, 2004, Ambac met all of these requirements. Prior to July 2004, Ambac and Ambac Assurance had a revolving credit facility with eight major international banks for $300,000. During 2004 and 2003, Ambac paid $481 and $457, respectively, for these credit facilities.

Ambac Assurance has a series of perpetual put options on its own preferred stock. The counterparty to these put options are trusts established by a major investment bank. The trusts were created as a vehicle for providing capital support to Ambac Assurance by allowing Ambac Assurance to obtain immediate access to new capital at its sole discretion at any time through the exercise of the put option. If the put option were exercised, Ambac Assurance would receive up to $800,000 in return for the issuance of its own perpetual preferred stock, the proceeds of which may be used for any purpose including the payment of claims. The preferred stock would give investors the rights of an equity investor in Ambac Assurance. Such rights are subordinate to insurance claims, as well as to the general unsecured creditors of Ambac Assurance. Dividend payments on the preferred stock are cumulative only if Ambac Assurance pays dividends on its common stock. Each trust is restricted to holding high quality short-term commercial paper investments to ensure that it can meet its obligations under the put option. To fund these investments, each trust has issued its own auction market perpetual securities. Ambac Assurance pays a put option fee. Each trust is rated AA/Aa2 by Standard & Poor’s and Moody’s respectively. During 2004 and 2003 Ambac paid put option fees of $4,698 and $4,671, respectively, which is recorded in adjusted paid-in capital on the consolidated financial statements.

From time to time Ambac accesses the capital markets to support the growth of its businesses. In April 2003, Ambac filed Form S-3 with the SEC utilizing a “shelf” registration process. Under this process, Ambac may issue up to $500 million of the securities described in the prospectus filed as part of the registration, namely, common stock, preferred stock and debt securities of Ambac.

8 OBLIGATIONS UNDER INVESTMENT AND PAYMENT AGREEMENTS

Obligations under investment agreements, including those structured in the form of repurchase contracts, are recorded on a trade-date basis. Certain obligations may be called at various times prior to maturity at the option of the counterparty. As of December 31, 2004, the interest rates on these agreements ranged from 1.10% to 8.08% with an average yield of 3.22%. As of December 31, 2003, the interest rates on these agreements ranged from 1.07% to 8.08% with an average yield of 3.41%. Obligations under investment agreements and investment repurchase agreements, excluding fair value hedge adjustments, were as follows:

As of December 31,	2004		2003
Settled	$	6,058,282	$	6,021,221
Unsettled		—		—
	$	6,058,282	$	6,021,221

Ambac Financial Group, Inc. and Subsidiaries    40

Notes to Consolidated Financial Statements

(Dollar Amounts in Thousands, Except Share Amounts)

Net payments due under settled investment agreements in each of the next five years ending December 31, and the periods thereafter, based on expected draw dates, are as follows:

	Principal Amount
2005	$	1,142,049
2006		507,827
2007		1,006,212
2008		834,184
2009		277,610
All later years		2,290,400
	$	6,058,282

Obligations under payment agreements represent funds received by Ambac from certain municipal customers. These funds serve as collateral for loans extended by Ambac in connection with certain structured municipal transactions. In connection with these transactions, Ambac is obligated to make periodic agreed upon payments. As of December 31, 2004 and 2003, the interest rates on these obligations ranged from 6.25% to 8.06% and from 6.25% to 8.42%, respectively. Net payments due under payment agreements in each of the next five years ending December 31, and the periods thereafter, based on contractual payment dates, are as follows:

	Principal Amount
2005	$	17,200
2006		21,611
2007		23,425
2008		31,427
2009		21,702
All later years		533,266
	$	648,631

9 INCOME TAXES

Ambac’s provision for income taxes charged to income from continuing operations is comprised of the following:

	2004		2003			2002
Current taxes	$	230,952	$	228,305		$	182,051
Deferred taxes		19,990		(6,815	)		(50,648	)
	$	250,942	$	221,490		$	131,403

The total effect of income taxes on income and stockholders’ equity for the years ended December 31, 2004 and 2003 was as follows:

	2004			2003
Total income taxes charged to income from continuing operations	$	250,942		$	221,490
Total income taxes (credited) charged to discontinued operations		(60	)		2,208
Total charged to net income		250,882			223,698
Income taxes charged (credited) to stockholders’ equity:
Unrealized gains (losses) on investment securities		6,763			(5,014	)
Unrealized gains on derivative hedges		11,879			2,710
Exercise of stock options		(29,545	)		(23,414	)
Total credited to stockholders’ equity		(10,903	)		(25,718	)
Total effect of income taxes	$	239,979		$	197,980

The tax provisions in the accompanying Consolidated Statements of Operations reflect effective tax rates differing from prevailing Federal corporate income tax rates. The following is a reconciliation of these differences:

	2004			%		2003			%		2002			%
Tax on income from continuing operations at statutory rate	$	341,874		35.0	%	$	297,356		35.0	%	$	197,166		35.0	%
Reductions in expected tax resulting from:
Tax-exempt interest		(79,564	)	(8.1	)		(73,652	)	(8.7	)		(63,211	)	(11.2	)
Release of tax reserves		(8,250	)	(0.8	)		—		0.0			—		0.0
Other, net		(3,118	)	(0.4	)		(2,214	)	(0.2	)		(2,552	)	(0.6	)
Tax expense on income from continuing operations	$	250,942		25.7	%	$	221,490		26.1	%	$	131,403		23.2	%

The release of tax reserves relates to the expiration of the statute of limitations of an earlier tax year.

41    Ambac Financial Group, Inc. and Subsidiaries

The tax effects of temporary differences that give rise to significant portions of the deferred tax liabilities and deferred tax assets at December 31, 2004 and 2003 are presented below:

	2004			2003
Deferred tax liabilities:
Contingency reserve	$	306,957		$	266,957
Unrealized gains on bonds		163,671			145,030
Deferred acquisition costs		71,141			62,835
Unearned premiums and credit fees		85,653			60,121
Investments		6,580			5,823
Other		3,020			7,199
Total deferred tax liabilities		637,022			547,965
Deferred tax assets:
Tax and loss bonds		271,371			231,371
Loss reserves		43,834			46,814
Compensation		38,405			39,114
Investment impairment loss		52,570			52,570
Other		13,469			7,038
Sub-total deferred tax assets		419,649			376,907
Valuation allowance		—			—
Total deferred tax assets		419,649			376,907
Net deferred tax liabilities	$	(217,373	)	$	(171,058	)

Ambac believes that no valuation allowance is necessary in connection with the deferred tax assets. It is more likely than not that the results of future operations will generate sufficient taxable income to realize the deferred tax assets.

10 SPECIAL PURPOSE ENTITIES AND VARIABLE INTEREST ENTITIES

Ambac has involvement with special purpose entities, including VIEs in the following ways. First, Ambac is a provider of financial guarantee insurance for various securitized asset-backed debt obligations. Second, Ambac has sponsored two special purpose entities that issue medium-term notes (“MTNs”) to fund the purchase of certain financial assets. As discussed in detail below, these Ambac sponsored special purpose entities are considered Qualifying Special Purpose Entities (“QSPEs”). Lastly, Ambac has a beneficial interest in a variable interest entity that purchases fixed rate municipal bonds with proceeds from the issuance of floating rate short term beneficial interests as discussed in detail below.

Financial Guarantees: Ambac provides financial guarantee insurance to securitized asset-backed debt obligations of special purpose entities, including VIEs. Ambac’s primary variable interest exists through this financial guarantee insurance contract. The transaction structure provides certain financial protection to Ambac. This financial protection can take several forms, however, the most common are over-collateralization, first loss retention and excess spread. In the case of over-collateralization (i.e., the principal amount of the securitized assets exceeds the principal amount of the structured finance obligations guaranteed by Ambac Assurance), the structure allows the transaction to experience defaults among the securitized assets before a default is experienced on the structured finance obligations that have been guaranteed by Ambac. In the case of first loss retention, the financial guarantee insurance policy only covers a senior layer of losses on debt issued by special purpose entities, including VIEs. The first loss with respect to the assets is either retained by the seller or sold off in the form of equity or mezzanine debt to other investors. In the case of excess spread, the financial assets contributed to special purpose entities, including VIEs, generate interest cash flows that are in excess of the interest payments on the related debt. All or a portion of this excess spread accumulates and is available to absorb losses in the transaction or is applied to create over-collateralization.

As of December 31, 2004, Ambac is the primary beneficiary and therefore consolidated VIEs under three transactions, as a result of providing financial guarantees to these entities. Ambac consolidated these entities since the structural financial protections are outside the VIEs. These structural protections, had they existed inside the VIEs, would have absorbed a majority of the VIEs’ expected losses and consequently Ambac would not have consolidated these entities. All consolidated VIEs are bankruptcy remote special purpose financing entities created to facilitate the sale of notes guaranteed by Ambac Assurance. Ambac is not primarily liable for the debt obligations of these entities. Ambac would only be required to make payments on these debt obligations in the event that the issuer defaults on any principal or interest due. Additionally, Ambac’s creditors do not have rights with regard to the assets of these VIEs.

Proceeds from the note issuance of the first VIE transaction, which closed in 2002, were used to purchase senior mortgage-backed floating rate notes of a Korean mortgage-backed securities issuer. Protections afforded Ambac Assurance in this transaction were in the form of a reserve fund and the issuance of subordinated debt. Ambac Assurance will pay claims under its financial guarantee only in the event that losses on the mortgage assets of the Korean issuer reduce the reserve fund to zero and exceed the principal amount of the subordinated notes. Total long-term debt outstanding under this note issuance was $119,504 with a maturity date of December 3, 2022 and a variable rate of interest which was 2.30% and 1.64% at December 31, 2004 and 2003, respectively.

Proceeds from the note issuances of the other transactions, both of which closed in 2004, were used to purchase notes issued by special purpose reinsurance companies in connection with their reinsurance of defined blocks of life insurance contracts. Protections afforded Ambac Assurance were in the form of capital contributed to the reinsurance companies and the issuance of subordinated debt by the VIEs. Ambac Assurance will pay claims under its financial guarantees in these transactions if cash flows generated under the reinsurance agreements and the proceeds from the contributed capital and subordinated debt are insufficient to repay the noteholders. Total debt outstanding under these note issuances were $954,864 at December 31, 2004, with maturity dates ranging from April 15, 2016 to February 4, 2025. At December 31, 2004 the interest rate on these notes ranged from 2.38% to 5.11%. Under one of these transactions, Ambac is subject to potential consolidation of an additional $350,000 of assets and liabilities in connection with future utilization of the VIE by the reinsurer.

Ambac Financial Group, Inc. and Subsidiaries    42

Notes to Consolidated Financial Statements

(Dollar Amounts in Thousands, Except Share Amounts)

The following table provides supplemental information about the combined assets and liabilities associated with the VIEs discussed above. The assets and liabilities of these VIEs are consolidated into the respective Balance Sheet captions.

At December 31,	2004		2003
Assets:
Cash	$	690	$	90
Loans		727,294		—
Investment in fixed income securities		346,111		189,151
Investment income due and accrued		2,315		241
Total	$	1,076,410	$	189,482
Liabilities:
Long-term debt	$	1,074,368	$	189,151
Other liabilities		2,042		331
Total	$	1,076,410	$	189,482

Disclosures made in Note 3, “Investments,” include investments in fixed income securities for all three VIE transactions. At December 31, 2004, the loan balance outstanding for one VIE transaction was $727,294 with a fixed interest rate of 4.906% and an expected final maturity date of April 2011.

Qualified Special Purpose Entities: 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. These entities meet the characteristics of QSPEs in accordance with Statement of Financial Accounting Standards 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities” (“SFAS 140”). QSPEs are not subject to the requirements of FIN 46-R and accordingly are not consolidated in Ambac’s financial statements. The QSPEs are legal entities that are demonstrably distinct from Ambac. Ambac, its affiliates or its agents cannot unilaterally dissolve the QSPEs. The QSPEs permitted activities are limited to those outlined below.

As of December 31, 2004, there have been 14 individual transactions (one in 2004) processed through the QSPEs of which 10 are outstanding. In each case, Ambac sells fixed income debt obligations to the QSPEs. These transactions are true sales based upon the bankruptcy remote nature of the QSPE and the absence of any agreement or obligation for Ambac to repurchase or redeem assets of the QSPE. The purchase by the QSPE is financed through the issuance of MTNs, which are collateralized by the purchased assets. The cash flows of the MTNs approximately match the cash flows of the assets purchased. Derivative contracts (interest rate and currency swaps) may be used for hedging purposes only. Derivative hedges are established at the time MTNs are issued to purchase financial assets. The activities of the QSPEs are contractually limited to purchasing assets from Ambac, issuing MTNs to fund such purchase, 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, 2004, Ambac Assurance had financial guarantee insurance policies issued for all assets and MTNs owned and outstanding by the QSPEs.

Ambac’s exposures under these financial guarantee insurance policies as of December 31, 2004 and December 31, 2003 are included in the disclosure in Note 15 “Guarantees in Force.” Pursuant to the terms of Ambac Assurance’s insurance policy, insurance premiums are paid to Ambac Assurance by the QSPEs and are earned in a manner consistent with other insurance policies, over the risk period. Any losses incurred would be included in Ambac’s Consolidated Statements of Operations. Under the terms of an Administrative Agency Agreement, Ambac provides certain administrative duties, primarily collecting amounts due on the obligations and making interest payments on the MTNs.

Assets sold to the QSPEs during 2004, 2003 and 2002 were $195,000, $250,000 and $350,000, respectively. No gains or losses were recognized on these sales. As of December 31, 2004, the estimated fair value of financial assets, MTN liabilities and derivative hedge liabilities were $2,011,868, $1,820,918 and $171,378, respectively. When market quotes are not available, estimated fair value is determined utilizing valuation models. These models include estimates, made by Ambac management, which utilize current market information. The valuation results from these models could differ materially from amounts that would actually be realized in the market. Ambac Assurance received gross premiums for issuing financial guarantee policies on the assets, MTNs and derivative contracts of $6,042, $5,278 and $19,255 for the years ended December 31, 2004, 2003 and 2002, respectively. Ambac also received fees for providing other services amounting to $393, $461 and $80 for 2004, 2003 and 2002, respectively.

VIE Beneficial Interest: Ambac owns a beneficial interest in a special purpose entity that meets the definition of a VIE. This entity has issued floating rate beneficial interests to investors and invested the proceeds in fixed income municipal investment securities. These beneficial interests are directly secured by the related municipal investment securities. Ambac is the primary beneficiary of this entity as a result of its beneficial interest. The fixed income municipal investment securities, which are reported as Investments in fixed income securities, at fair value on the Consolidated Balance Sheets, were $257,300 and $254,756 as of December 31, 2004 and 2003. The beneficial interests issued to third parties, are reported as Obligations under investment and payment agreements on the Consolidated Balance Sheets, were $249,140 and $249,810 as of December 31, 2004 and 2003. As of December 31, 2004 and 2003, the interest rates on these beneficial interests ranged from 0.87% to 2.03% and from 0.68% to 1.42%, respectively.

43    Ambac Financial Group, Inc. and Subsidiaries

11 PENSION AND POSTRETIREMENT BENEFITS

Pensions: Ambac has a defined benefit pension plan covering substantially all employees of Ambac. The benefits are based on years of service and the employee’s highest salary during five consecutive years of employment within the last ten years of employment. Ambac’s funding policy is to contribute annually the maximum amount that can be deducted for Federal income tax purposes. Contributions for 2005 are estimated to be approximately $1,000. Contributions are intended to provide not only for benefits attributed to service-to-date, but also for those expected to be earned in the future.

The table below sets forth a reconciliation of the beginning and ending projected benefit obligation, beginning and ending balances of the fair value of plan assets, and the funded status of the plan as of December 31, 2004 and 2003.

	2004			2003
Accumulated Benefit Obligations at End of Year:	$	19,304		$	17,255
Change in Projected Benefit Obligation:
Projected benefit obligation at beginning of year	$	23,037		$	18,030
Service cost		1,697			1,653
Interest cost		1,284			1,151
Actuarial (gain) loss		(266	)		2,447
Benefits paid		(323	)		(244	)
Projected benefit obligation at end of year	$	25,429		$	23,037
Change in Plan Assets:
Fair value of plan assets at beginning of year	$	21,998		$	12,521
Actual return on plan assets		2,843			4,021
Company contributions		2,300			5,700
Benefits paid		(323	)		(244	)
Fair value of plan assets at end of year	$	26,818		$	21,998
Funded status	$	1,389		$	(1,039	)
Unrecognized loss		4,342			5,566
Unrecognized prior service cost		(70	)		(118	)
Prepaid pension asset	$	5,661		$	4,409

Ambac employs a total return investment approach whereby a mix of equity and bond mutual funds are used to maximize the long-term return of plan assets for a prudent level of risk. Risk tolerance is established through careful consideration of plan liabilities, plan funded status, and corporate financial condition. The plan strives to have diversification so that adverse or unexpected results from one security class will not have an unduly detrimental impact on the entire portfolio. The investment policy establishes a target allocation for each class which is rebalanced as deemed necessary. Target asset allocations are 40% large capitalization U.S. equity index mutual funds, 30% U.S. bond index mutual funds, 20% international equity mutual funds and 10% small capitalization U.S. equity mutual funds.

The fair value of total plan assets at December 31, 2004 and 2003 by asset category were as follows:

	2004		2003
Equity mutual funds	74	%	72	%
Bond mutual funds	26	%	28	%
	100	%	100	%

Net pension costs for 2004, 2003 and 2002 included the following components:

	2004			2003			2002
Service cost	$	1,697		$	1,653		$	1,397
Interest cost		1,283			1,151			992
Expected return on plan assets		(2,027	)		(1,664	)		(1,289	)
Amortization of prior service cost		(144	)		(131	)		(131	)
Recognized net loss		102			37			—
Other		136			—			—
Net periodic pension cost	$	1,047		$	1,046		$	969

The following assumptions were used to determine the projected benefit obligation at the measurement date (December 31, 2004) and the net periodic pension cost for the year:

Projected Benefit Obligation:			2004		2003
Discount rate			5.75	%	6.00	%
Rate of compensation increase			4.50	%	4.50	%
Net Periodic Pension Cost:	2004		2003		2002
Discount rate	6.00	%	6.50	%	7.00	%
Expected long-term return on plan assets	8.75	%	8.75	%	8.75	%
Rate of compensation increase	4.50	%	4.50	%	4.50	%

The return on plan assets reflects the weighted-average of the expected long-term rates of return for the security classes of investments. Consideration is given for historical returns and current economic conditions.

Postretirement Health Care and Other Benefits: Ambac provides certain medical and life insurance benefits for retired employees and eligible dependents. All plans are contributory. None of the plans are currently funded.

Postretirement benefits expense was $207, $171 and $119 in 2004, 2003 and 2002, respectively. The unfunded accumulated postretirement benefit obligation was $3,264 and the related accrued postretirement liability was $3,537 as of December 31, 2004.

The assumed health care cost trend rates range from 10.5% in 2005, decreasing ratably to 6% in 2010. Increasing the assumed health care cost trend rate by one percentage point in each future year would increase the accumulated postretirement benefit obligation at December 31, 2004, by $797 and the 2004 benefit expense by $118. Decreasing the assumed health care cost trend rate by one percentage point in each future year would decrease the accumulated postretirement benefit obligation at December 31, 2004 by $517 and the 2004 benefit expense by $94. The discount rate used to measure the accumulated postretirement benefit obligation was 5.75% and 6.0% for 2004 and 2003, respectively.

Ambac Financial Group, Inc. and Subsidiaries    44

Notes to Consolidated Financial Statements

(Dollar Amounts in Thousands, Except Share Amounts)

The following table sets forth projected benefit payments from Ambac’s defined benefit pension and postretirement plans and reflects expected future service where appropriate:

	Amount
2005	$	598
2006		696
2007		763
2008		849
2009		970
All later years		7,319
	$	11,195

12 INCENTIVE PLANS

The Ambac 1997 Equity Plan (the “Equity Plan”) provides for the granting of stock options, stock appreciation rights, restricted stock units (“RSUs”), performance units and other awards that are valued or determined by reference to the Common Stock. Ambac also maintains the Ambac 1997 Non-Employee Directors Equity Plan, which provides awards of stock options and restricted stock units to non-employee members of the Ambac’s Board of Directors. As of December 31, 2004, approximately 8,820,475 shares were available for future grant under the Equity Plan and the Directors Equity Plan. The number of options and their exercise price, and the number of restricted stock units awarded to each non-employee director under the Directors Equity Plan are determined by formula.

Stock Options: Stock options awarded to employees are exercisable and expire as specified at the time of grant. Such options do not have a per share exercise price less than the fair market value of a share of Common Stock on the date of grant or have a term in excess of ten years from the date of the grant. All employee stock option agreements provide that vesting is accelerated in certain circumstances, such as upon retirement or death. A summary of option activity is as follows:

	2004				2003				2002
	Shares		Weighted- Average Exercise Price		Shares		Weighted- Average Exercise Price		Shares		Weighted- Average Exercise Price
Outstanding at beginning of year	5,812,402		$	48.59	6,623,063		$	42.08	6,302,745		$	34.66
Granted	477,206		$	73.74	1,629,595		$	58.24	1,565,192		$	59.09
Exercised	(1,655,077	)	$	41.25	(2,022,010	)	$	33.52	(1,128,095	)	$	23.58
Forfeited	(83,211	)	$	57.69	(418,246	)	$	55.97	(116,779	)	$	52.66
Outstanding at end of year	4,551,320		$	43.54	5,812,402		$	48.59	6,623,063		$	42.08
Exercisable	3,112,253				2,722,567				4,256,091

	Options Outstanding				Options Exercisable
Range of Exercise Prices	Number Outstanding at December 31, 2004	Weighted Average Remaining Contract Life	Weighted Average Exercise Price		Number Exercisable at December 31, 2004	Weighted Average Exercise Price
$13 to 35	551,744	1.9	$	30.18	551,744	$	30.18
$36 to 55	1,026,900	2.4	$	45.07	1,024,900	$	45.18
$56 to 78	2,972,676	4.6	$	61.04	1,535,609	$	59.50
	4,551,320				3,112,253

45    Ambac Financial Group, Inc. and Subsidiaries

Refer to Note 2 for a further description of the accounting for common stock incentives and a presentation of the effect on net income and earnings per share. The fair values of stock based awards are based on assumptions determined at the grant date.

The weighted-average fair value (determined as of the date of the grants) of options granted in 2004, 2003 and 2002 was $16.93 per share, $14.13 per share, and $20.64 per share, respectively. The fair value of each option grant issued was estimated as of the date of the grant using the Black-Scholes option-pricing model, with the following weighted-average assumptions used for grants in 2004, 2003 and 2002:

	2004		2003		2002
Risk-free interest rate	2.6	%	2.3	%	4.2	%
Expected volatility	28.0	%	31.5	%	31.9	%
Dividend yield	0.60	%	0.70	%	0.61	%
Expected life	4 years		4 years		5 years

Annual Incentive Program: Ambac has an annual incentive program (the “Program”) that makes available to all eligible employees awards that are based upon the performance of Ambac, the performance of the employee’s department and the performance of the employee. The Program awards consist of cash and RSUs for all employees and, in lieu of a predetermined percentage of cash, RSUs that may be granted to officers at the level of Managing Director and above. RSUs granted in lieu of the first twenty-five percent of the cash award are granted at a twenty-five percent discount to the average of the high and low of Ambac common stock on the date of grant. An eligible employee can elect to defer more than twenty-five percent of their cash award in the form of RSUs, however, the aforementioned discount does not apply. RSUs granted in lieu of the cash award vest equally over three years. The RSUs representing the twenty-five percent discount vest on the fourth anniversary of the date of grant. Prior to vesting, the RSUs cannot be sold or transferred by the participant and are subject to cancellation if the participant’s employment is terminated. All RSU agreements provide that vesting is accelerated in certain circumstances, such as retirement or death. Of the total RSUs outstanding at December 31, 2004 (i) 467,149 units require future service as a condition to the delivery of the underlying shares of common stock and (ii) 1,220,624 units did not require future service. The expense of the cash component of the program for the years ended December 31, 2004, 2003 and 2002 amounted to $37,447, $33,346 and $30,775, respectively.

Information with respect to the RSU awards is as follows:

	2004		2003		2002
RSUs Awarded		380,779		103,151		77,811
Weighted average fair value per share	$	73.65	$	56.19	$	58.95
Compensation expense	$	11,420	$	6,425	$	2,706

Savings Incentive Plan: Substantially all employees of Ambac are covered by a defined contribution plan (the “Savings Incentive Plan”), for which contributions are determined as 6% of each eligible employee’s eligible base salary, plus a matching company contribution of 50% on contributions up to 6% of base salary made by eligible employees to the Savings Incentive Plan. The total cost of the Savings Incentive Plan was $3,256, $3,508 and $2,565 in 2004, 2003 and 2002, respectively.

13 COMMITMENTS AND CONTINGENCIES

Ambac is responsible for leases on the rental of office space. The lease agreements, which expire periodically through September 2019, contain provisions for scheduled periodic rent increases and are accounted for as operating leases. An estimate of future net minimum lease payments in each of the next five years ending December 31, and the periods thereafter, is as follows:

	Amount
2005	$	8,017
2006		7,864
2007		7,654
2008		7,896
2009		8,256
All later years		84,060
	$	123,747

Rent expense for the aforementioned leases amounted to $8,507, $7,434 and $6,377 for the years ended December 31, 2004, 2003 and 2002, respectively. Total future rental receipts under lease and sublease agreements are estimated at $326.

A subsidiary of Ambac Financial Group provides a $360,000 liquidity facility to a reinsurance company which acts as reinsurer with respect to a portfolio of life insurance policies. The liquidity facility provides temporary funding in the event that the reinsurance company’s capital is insufficient to make payments under the reinsurance agreement. The reinsurance company is required to repay all amounts drawn under the liquidity facility. No amounts have been drawn under this facility at December 31, 2004.

14 STOCKHOLDERS’ EQUITY

Ambac is authorized to issue 350,000,000 shares of Common Stock, par value $0.01 per share, of which 108,915,944 were issued as of December 31, 2004. Ambac is also authorized to issue 4,000,000 shares of Preferred Stock, $0.01 par value per share, none of which was issued and outstanding as of December 31, 2004.

Dividends declared per share amounted to $0.47, $0.42, and $0.38 in 2004, 2003, and 2002, respectively.

Stockholder Rights Plan: Ambac adopted a Stockholder Rights Plan under which stockholders received (after giving effect to two stock splits since adoption of the Plan) one Right for each three shares of Common Stock owned. Each Right entitles the registered holder to purchase from Ambac one one-hundredth of a share of Series A Junior Participating Preferred Stock, par value $0.01 per share, at a purchase price of $190 per share. The Rights generally detach and become exercisable when any person or group acquires 20% or more (or announces a tender offer for 20% or more) of Ambac’s Common Stock. In addition, in the event that any person or group acquires 20% or more of Ambac’s Common Stock, each Right (other than those held by the acquiring company) will entitle the holder to receive that number of shares of Common Stock of Ambac with a value of two times the exercise price of the Right. If, following the date on which any person or group acquires 20% or more of Ambac’s Common Stock, Ambac is acquired in a merger or other business combination transaction in which Ambac is not the surviving corporation or 50% or more of Ambac’s assets, cash flow or earning power is sold or transferred, each Right will entitle the holder to receive that number of

Ambac Financial Group, Inc. and Subsidiaries    46

Notes to Consolidated Financial Statements

(Dollar Amounts in Thousands, Except Share Amounts)

shares of stock of the acquiring company having a value equal to two times the exercise price of the Right. The Rights, which expire on January 31, 2006, are redeemable in whole, but not in part, by action of the Board of Directors of Ambac at a price of $0.01 per Right at any time prior to the tenth day following the date on which any person or group acquires 20% or more of Ambac’s Common Stock.

15 GUARANTEES IN FORCE

The par amount of financial guarantees outstanding, net of reinsurance, was $459,432,000 and $425,854,000 at December 31, 2004 and 2003, respectively. As of December 31, 2004 and 2003, the guarantee portfolio was diversified by type of guaranteed bond as shown in the following table:

	Net Par Amount Outstanding(1)
(Dollars in Millions)	2004		2003
Public Finance:
Lease and tax-backed	$	76,012	$	66,331
General obligation		49,394		44,350
Utility revenue		36,321		33,598
Health care revenue		23,977		22,120
Transportation revenue		21,188		18,244
Higher education		18,056		15,778
Housing revenue		9,163		9,014
Other		5,588		5,879
Total Public Finance		239,699		215,314
Structured Finance:
Mortgage-backed and home equity		53,148		50,819
Asset-backed and conduits(2)		28,858		27,126
Investor-owned utilities		15,449		14,480
Student loan		14,646		12,807
Pooled debt obligations		13,382		11,492
Other		6,971		7,400
Total Structured Finance		132,454		124,124
International Finance:
Pooled debt obligations		35,911		44,723
Mortgage-backed and home equity		19,644		17,273
Asset-backed and conduits		15,692		12,503
Investor-owned and public utilities		5,965		4,677
Transportation revenue		4,938		3,698
Sovereign/sub-sovereign		3,224		2,353
Other		1,905		1,189
Total International Finance		87,279		86,416
	$	459,432	$	425,854

(1) Included in the above exposures are structured credit derivatives. Total structured credit derivative net par outstanding amounted to $43,478 and $48,825 at December 31, 2004 and 2003, respectively.

(2) Included within Asset-backed and conduits are exposures to Enhanced Equipment Trust Certificates of $1,827 and $1,667 at December 31, 2004 and 2003, respectively.

As of December 31, 2004 and 2003, the International Finance guaranteed portfolio is shown in the following table by location of risk:

	Net Par Amount Outstanding
(Dollars in Millions)	2004		2003
United Kingdom	$	26,325	$	17,990
Germany		7,842		11,617
Japan		6,063		6,058
Australia		4,569		3,620
Italy		1,641		1,633
Internationally diversified		32,685		38,243
Other international		8,154		7,255
Total International Finance	$	87,279	$	86,416

Internationally diversified obligations represent pools of geographically diversified exposures which includes components of domestic exposure.

Direct financial guarantees in force (principal and interest) was $757,037,000 and $707,131,000 at December 31, 2004 and 2003, respectively. Net financial guarantees in force (after giving effect to reinsurance) was $685,234,000 and $625,564,000 as of December 31, 2004 and 2003, respectively.

In the United States, California and New York were the states with the highest aggregate net par amounts in force, accounting for 10.0% and 6.3% of the total at December 31, 2004. No other state accounted for more than five percent. The highest single insured risk represented less than 1% of aggregate net par amount insured.

16 FAIR VALUE OF FINANCIAL INSTRUMENTS

The following fair value amounts were determined by using independent market information when available, and valuation models when market quotes were not available. In cases where specific market quotes are unavailable, interpreting market data and estimating fair values require considerable judgment by management. Accordingly, the estimates presented are not necessarily indicative of the amount Ambac could realize in a current market exchange. The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value:

Investments: The fair values of fixed income investments are based primarily on quoted market prices received from a nationally recognized pricing service or dealer quotes. When quotes are not available, fair values are estimated based upon internal valuation models.

Short-term investments and cash: The fair values of short-term investments and cash are assumed to approximate amortized cost.

Other investments: The fair value of other investments, primarily mutual funds, are based on quoted market prices received from a nationally recognized pricing service.

47    Ambac Financial Group, Inc. and Subsidiaries

Securities purchased under agreements to resell: The fair value of securities purchased under agreements to resell is assumed to approximate carrying value.

Investment income due and accrued: The fair value of investment income due and accrued is assumed to approximate carrying value.

Loans: The fair values of loans are assumed to approximate carrying value.

Derivative contracts used for hedging purposes: The fair values of cash flow hedges and fair value hedges, as defined in Note 2, are determined by market quotes or valuation models when market quotes are not available.

Derivative contracts held for trading purposes: The fair values of interest rate swaps, currency swaps, total return swaps and structured credit derivative transactions, as discussed in Note 2, are determined by market quotes or valuation models when market quotes are not available.

Obligations under investment, payment and investment repurchase agreements: The fair value of the liability for investment agreements and repurchase agreements is estimated based upon internal valuation models. The fair value of payment agreements is assumed to approximate carrying value.

Securities sold under agreements to repurchase: The fair value of securities sold under agreements to repurchase is assumed to approximate carrying value.

Long-term Debt: The fair value of the debentures is based on quoted market prices. The fair value of long-term debt issued by consolidated variable interest entities are assumed to approximate carrying value.

Accrued interest payable: The fair value of accrued interest payable is assumed to approximate carrying value.

Liability for net financial guarantees written: The fair value of the liability for those financial guarantees written is based on the estimated cost to reinsure those exposures at current market rates, which amount consists of the current unearned premium reserve, less an estimated ceding commission thereon.

Other financial guarantee insurance policies have been written on an installment basis, where the future premiums to be received by Ambac are determined based on the outstanding exposure at the time the premiums are due. The fair value of Ambac Assurance’s liability under its installment premium policies is measured using the present value of estimated future installment premiums, less an estimated ceding commission. The estimate of the amounts and timing of the future installment premiums is based on contractual premium rates, debt service schedules and expected run-off scenarios. This measure is used as an estimate of the cost to reinsure Ambac Assurance’s liability under these policies.

The carrying amount and estimated fair value of financial instruments are presented below:

	As of December 31,
	2004				2003
(Dollars in Millions)	Carrying Amount		Estimated Fair Value		Carrying Amount		Estimated Fair Value
Financial assets:
Fixed income securities	$	13,901	$	13,901	$	13,049	$	13,049
Fixed income securities pledged as collateral		342		342		661		661
Short-term investments		521		521		250		250
Other investments		4		4		4		4
Cash		20		20		25		25
Securities purchased under agreements to resell		353		353		54		54
Investment income due and accrued		163		163		160		160
Loans		1,406		1,406		838		838
Derivative assets:
Hedging purposes		158		158		142		142
Trading purposes		1,140		1,140		1,004		1,004
Financial liabilities:
Obligations under investment, repurchase and payment agreements		7,081		7,149		7,076		7,124
Securities sold under agreements to repurchase		—		—		226		226
Long-term debt		1,866		1,931		981		1,055
Accrued interest payable		71		71		74		74
Derivative liabilities:
Hedging purposes		—		—		—		—
Trading purposes		1,049		1,049		946		946
Liability for financial guarantees written:
Gross		2,779		2,084		2,545		1,782
Net of reinsurance		2,482		1,862		2,220		1,554
Gross installment premiums		—		1,769		—		1,311
Net installment premiums		—		1,545		—		1,089

Ambac Financial Group, Inc. and Subsidiaries    48

Notes to Consolidated Financial Statements

(Dollar Amounts in Thousands, Except Share Amounts)

17 INSURANCE REGULATORY RESTRICTIONS

Ambac Assurance is subject to insurance regulatory requirements of the States of Wisconsin and New York, and the other jurisdictions in which it is licensed to conduct business.

Ambac Assurance’s ability to pay dividends is generally restricted by law and subject to approval by the Office of the Commissioner of Insurance of the State of Wisconsin. Wisconsin insurance law restricts the payment of dividends in any 12 month period without regulatory approval to the lesser of (a) 10% of policyholders’ surplus as of the preceding December 31 and (b) the greater of (i) statutory net income for the calendar year preceding the date of dividend, minus realized capital gains for that calendar year and (ii) the aggregate of statutory net income for three calendar years preceding the date of the dividend, minus realized capital gains for those calendar years and minus dividends paid or credited within the first two of the three preceding calendar years. Based upon these restrictions, at December 31, 2004, the maximum amount that will be available during 2005 for payment of dividends by Ambac Assurance is approximately $320,000. Ambac Assurance paid cash dividends of $103,000, $89,600 and $78,000 on its common stock in 2004, 2003 and 2002, respectively.

The New York Financial Guarantee Insurance Law establishes single risk limits applicable to obligations insured by Ambac Assurance. Such limits are specific to the type of insured obligation (for example, municipal or asset-backed). The limits compare the insured net par outstanding and average annual debt service, 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 of December 31, 2004 and 2003, Ambac Assurance and its subsidiaries were in compliance with these regulatory requirements.

Ambac Assurance’s statutory financial statements are prepared on the basis of accounting practices prescribed or permitted by the Wisconsin Insurance Department. Effective January 1, 2001, Wisconsin adopted the National Association of Insurance Commissioners’ statutory accounting practices (“NAIC SAP”) as a component of its prescribed accounting practices. Wisconsin’s accounting practice for changes to the contingency reserve differ from those practices of NAIC SAP. Under NAIC SAP, contributions to and releases from the contingency reserve are recorded via a direct charge or credit to surplus. Under the Wisconsin Administrative Code, contributions to and release from the contingency reserve are to be recorded through underwriting income. Ambac Assurance received permission of the Wisconsin Insurance Commissioner to record contributions to and releases from the contingency reserve in accordance with NAIC SAP. Statutory surplus is the same using each of these accounting practices. Statutory net income is higher than if Ambac Assurance had reported the net contributions in accordance with the Wisconsin Administrative Code by $235,881, $234,219 and $169,015 for 2004, 2003 and 2002, respectively.

Statutory capital and surplus was $3,198,699, and $2,739,675 at December 31, 2004 and 2003, respectively. Qualified statutory capital was $5,224,491 and $4,525,991 at December 31, 2004 and 2003, respectively. Statutory net income for Ambac Assurance was $693,176, $584,160 and $486,246 for 2004, 2003 and 2002, respectively. Statutory capital and surplus differs from stockholders’ equity determined under GAAP principally due to statutory accounting rules that treat loss reserves, premiums earned, policy acquisition costs, and deferred income taxes differently.

18 SEGMENT INFORMATION

Ambac has two reportable segments, as follows: (1) Financial Guarantee, which provides financial guarantees (including structured credit derivatives) for public finance, structured finance and other obligations; and (2) Financial Services, which provides investment agreements, interest rate swaps, total return and currency swaps and funding conduits, principally to clients of the financial guarantee business, which includes municipalities and other public entities, health care organizations and asset-backed issuers. Ambac’s reportable segments are strategic business units that offer different products and services. They are managed separately because each business requires different marketing strategies, personnel skill sets and technology.

The accounting policies of the segments are described in Note 2, “Significant Accounting Policies.” Pursuant to insurance and indemnity agreements, Ambac Assurance guarantees the swap and investment agreement obligations of those Financial Services subsidiaries. Intersegment revenues include the premiums earned under those agreements and dividends received. Such premiums are determined as if they were premiums to third parties, that is, at current market prices.

Information provided below for “Corporate and Other” relates to Ambac Financial Group, Inc. corporate activities, including interest expense on debentures. Corporate and other revenue from unaffiliated customers consists primarily of interest income. Intersegment revenues consist of dividends received.

49    Ambac Financial Group, Inc. and Subsidiaries

The following table is a summary of the financial information from continuing operations by reportable segment as of and for the years ended December 31, 2004, 2003 and 2002:

	Financial Guarantee		Financial Services			Corporate and Other			Intersegment Eliminations			Total Consolidated
2004:
Revenues:
Unaffiliated customers	$	1,168,707	$	236,345		$	1,656		$	—		$	1,406,708
Intersegment		23,255		(5,571	)		108,240			(125,924	)		—
Total revenues	$	1,191,962	$	230,774		$	109,896		$	(125,924	)	$	1,406,708
Income before income taxes:
Unaffiliated customers	$	987,400	$	52,731		$	(63,349	)	$	—		$	976,782
Intersegment		28,823		(5,779	)		105,747			(128,791	)		—
Total income before income taxes	$	1,016,223	$	46,952		$	42,398		$	(128,791	)	$	976,782
Total assets	$	10,079,923	$	8,440,952		$	64,383		$	—		$	18,585,258
2003:
Revenues:
Unaffiliated customers	$	1,033,578	$	231,372		$	7,258		$	—		$	1,272,208
Intersegment		21,175		(5,430	)		95,480			(111,225	)		—
Total revenues	$	1,054,753	$	225,942		$	102,738		$	(111,225	)	$	1,272,208
Income before income taxes:
Unaffiliated customers	$	888,143	$	22,951		$	(61,505	)	$	—		$	849,589
Intersegment		23,441		(3,646	)		93,776			(113,571	)		—
Total income before income taxes	$	911,584	$	19,305		$	32,271		$	(113,571	)	$	849,589
Total assets	$	8,234,050	$	8,433,834		$	79,430		$	—		$	16,747,314
2002:
Revenues:
Unaffiliated customers	$	816,178	$	137,447		$	5,019		$	—		$	958,644
Intersegment		7,984		(4,477	)		81,500			(85,007	)		—
Total revenues	$	824,162	$	132,970		$	86,519		$	(85,007	)	$	958,644
Income before income taxes:
Unaffiliated customers	$	712,930	$	(103,724	)	$	(45,875	)	$	—		$	563,331
Intersegment		8,920		(2,489	)		80,192			(86,623	)		—
Total income before income taxes	$	721,850	$	(106,213	)	$	34,317		$	(86,623	)	$	563,331
Total assets	$	7,035,628	$	8,245,629		$	74,281		$	—		$	15,355,538

Ambac Financial Group, Inc. and Subsidiaries    50

Notes to Consolidated Financial Statements

(Dollar Amounts in Thousands, Except Share Amounts)

The following tables summarize gross premiums written and net premiums earned included in the Financial Guarantee segment, by location of risk for the years ended December 31, 2004, 2003 and 2002:

	2004		2003		2002
Gross premiums written:
United States	$	819,321	$	913,262	$	766,778
United Kingdom		110,225		106,315		38,495
Japan		28,836		25,783		22,033
Mexico		15,007		16,395		16,513
Italy		11,690		12,842		860
Brazil		10,846		10,193		7,239
Australia		5,026		4,761		8,930
Internationally diversified		28,970		29,751		16,841
Other international		17,890		24,401		26,343
Total:	$	1,047,811	$	1,143,703	$	904,032
Net premiums earned and other credit enhancement fees:
United States	$	553,717	$	497,784	$	382,409
United Kingdom		60,731		34,993		19,287
Japan		32,141		25,965		17,941
Mexico		7,242		7,620		7,720
Italy		8,003		6,487		777
Brazil		8,282		6,978		4,827
Australia		7,246		5,493		4,945
Internationally diversified		55,814		58,297		40,926
Other international		30,809		23,633		21,477
Total:	$	763,985	$	667,250	$	500,309

Internationally diversified includes components of domestic exposure.

19 DISCONTINUED OPERATIONS

In November 2003, Ambac announced that it had entered into an agreement to sell the operations of Cadre Financial Services, Inc. (“Cadre”) and Ambac Securities, Inc., (“Ambac Securities”) its investment advisory and cash management business. As a registered adviser with the SEC, Cadre was subject to regulation in certain aspects of its business, particularly with respect to investment advisory services provided to investment companies and clients. Cadre provided investment advisory and administrative services to money market funds that are primarily offered to qualified participants, including school districts, health care service providers and municipalities. Ambac Securities principal business was the distribution of money market funds to the education, health care and municipal sectors, as well as the brokering of short-term fixed income securities trades on behalf of its clients. It also served as placement agent and dealer for securities issued by its affiliates in private placement transactions. Ambac Securities is registered as a broker-dealer with the SEC and with certain states that require such registration, and it is a member of the National Association of Securities Dealers, Inc. 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. This business had been part of Ambac’s Financial Services segment. The decision to sell its investment advisory and cash management business has enabled Ambac to focus on its core financial guarantee business. The sale closed during the first quarter of 2004.

Following the November 2003 announcement of the pending sale, Cadre and Ambac Securities results were reported in Ambac’s Consolidated Statements of Operations as discontinued operations. Summarized financial information for discontinued operations is as follows:

	2004			2003			2002
Total revenues	$	469		$	11,581		$	13,174
(Loss) income from discontinued operations		(1,349	)		(6,976	)		859
Income tax (benefit) expense		(60	)		2,208			193
Net (loss) income from discontinued operations		(1,289	)		(9,184	)		666

The following information is a summary of the discontinued operations balance sheet in 2003:

	2003
Total assets	$	8,787
Total liabilities		4,277

51    Ambac Financial Group, Inc. and Subsidiaries

20 QUARTERLY FINANCIAL INFORMATION (unaudited)

	First			Second			Third			Fourth			Full Year
2004:
Gross premiums written	$	226,434		$	363,196		$	210,587		$	247,594		$	1,047,811
Net premiums written		192,548			379,145			191,938			213,234			976,865
Net premiums earned and other credit enhancement fees		176,871			201,402			195,338			190,374			763,985
Financial guarantee net investment income		87,715			88,919			90,454			93,998			361,086
Financial services revenue		65,784			53,371			58,096			59,094			236,345
Losses and loss expenses		17,500			17,500			17,700			16,900			69,600
Financial guarantee underwriting and operating expenses		25,836			29,277			26,186			25,264			106,563
Financial services expenses		46,387			44,059			45,085			48,083			183,614
Income before income taxes		231,121			244,458			246,050			255,153			976,782
Net income from continuing operations		171,755			180,896			184,418			188,771			725,840
Net loss from discontinued operations		(144	)		(186	)		(959	)		—			(1,289	)
Net income		171,611			180,710			183,459			188,771			724,551
Net income per share:
Basic		1.57			1.65			1.67			1.72			6.61
Diluted	$	1.55		$	1.63		$	1.65		$	1.69		$	6.53
2003:
Gross premiums written	$	197,219		$	386,005		$	280,330		$	280,149		$	1,143,703
Net premiums written		166,051			343,692			262,879			232,935			1,005,557
Net premiums earned and other credit enhancement fees		145,116			164,286			171,562			186,286			667,250
Financial guarantee net investment income		76,595			79,892			80,890			83,712			321,089
Financial services revenue		65,528			50,624			63,328			51,892			231,372
Losses and loss expenses		9,800			10,900			15,900			16,800			53,400
Financial guarantee underwriting and operating expenses		22,166			21,013			23,795			25,061			92,035
Financial services expenses		56,389			52,717			49,240			50,075			208,421
Income before income taxes		181,680			220,226			217,067			230,616			849,589
Net income from continuing operations		138,062			162,757			160,081			167,199			628,099
Net loss from discontinued operations		(139	)		(186	)		(412	)		(8,447	)		(9,184	)
Net income		137,923			162,571			159,669			158,752			618,915
Net income per share:
Basic		1.30			1.53			1.50			1.48			5.81
Diluted	$	1.27		$	1.48		$	1.45		$	1.44		$	5.66

Ambac Financial Group, Inc. and Subsidiaries    52

Stockholder Information

Corporate Headquarters: AMBAC FINANCIAL GROUP, INC. One State Street Plaza New York, New York 10004 Tel: 212-668-0340 Fax: 212-509-9190 Other Locations: LONDON Hasilwood House 60 Bishopsgate London EC2N 4BE, England Tel: 44 207 786 4300 Fax: 44 207 786 4343 MILAN Via Monte di Pietá 21 20121 Milan Italy Tel: 39 02 86 337642 Fax: 39 02 86 337400 VITO SEMERARO Managing Director SYDNEY ABN AMRO Tower, L31 88 Phillip Street Sydney 2000 NSW, Australia Tel: 61 2 8211 0430 Fax: 61 2 8211 0555 NANCY S. FOX Managing Director TOKYO Otemachi Financial Center, 17th Floor 5-4, Otemachi 1-chome, Chiyoda-ku, Tokyo 100-0004 Japan Tel: 03 5219 2127 Fax: 03 5219 2129 HIDESHI AMEMIYA Representative Director Annual Meeting of Stockholders The Annual Meeting of Stockholders of Ambac Financial Group, Inc. will be held on Tuesday, May 3, 2005, at 11:30 a.m. in New York City. Detailed information about the meeting is contained in the Notice of Annual Meeting and Proxy Statement to be sent to each stockholder of record as of March 7, 2005. The Company estimates that it has approximately 45,000 stockholders. Form 10-K A copy of the Company’s 2004 Annual Report on Form 10-K for the year ended December 31, 2004, as filed with the Securities and Exchange Commission, may be obtained without charge by writing to: Ambac Financial Group, Inc. Attn: Investor Relations One State Street Plaza New York, New York 10004 SEC Certifications The certifications by the Chief Executive Officer and the Chief Financial Officer of Ambac Financial Group, Inc., required under Section 302 of the Sarbanes-Oxley Act of 2002, have also been filed as exhibits to the firm’s 2004 Annual Report on Form 10-K. Transfer Agent, Registrar and Dividend Paying Agent Citibank, N.A. 111 Wall Street, 5th Floor New York, New York 10043 212-657-5997 Independent Auditors KPMG LLP New York, New York Stock Listing Ambac Financial Group, Inc. common stock is listed on the New York Stock Exchange under the ticker symbol ABK. Investor Relations THOMAS J. GANDOLFO Senior Vice President and Chief Financial Officer PETER R. POILLON Managing Director 212-208-3333 800-221-1854 ppoillon@ambac.com NYSE Certifications The Chief Executive Officer of Ambac Financial Group, Inc. made an unqualified certification to the NYSE with respect to the firm’s compliance with the NYSE corporate governance listing standards in May 2004.

Common Stock Data

	2004 MARKET PRICE					2003 MARKET PRICE
THREE MONTHS ENDED	HIGH	LOW	CLOSE	DIVIDENDS PER SHARE		HIGH	LOW	CLOSE	DIVIDENDS PER SHARE
MARCH 31	79.76	68.86	73.78	$	0.11	59.36	43.79	50.52	$	0.10
JUNE 30	75.93	63.80	73.44	$	0.11	70.56	50.35	66.25	$	0.10
SEPTEMBER 30	79.95	69.21	79.95	$	0.125	69.00	62.18	64.00	$	0.11
DECEMBER 31	84.73	72.34	82.13	$	0.125	72.21	64.60	69.39	$	0.11

“Financial peace of mind” is a trademark of Ambac Financial Group, Inc.

EX-21.01

EXHIBIT 21.01

List of Subsidiaries of Ambac Financial Group, Inc.

The following is a list of significant and other subsidiaries of Ambac Financial Group, Inc. The state of incorporation of each subsidiary is included in parentheses after its name.

Ambac Assurance Corporation (Wisconsin)

Ambac Assurance UK Limited (United Kingdom Insurance Company)

Ambac Capital Corporation (Delaware)

Ambac Capital Funding, Inc. (Delaware)

Ambac Credit Products, LLC (Delaware)

Ambac Investments, Inc. (Delaware)

Ambac Financial Services, LLC (Delaware)

EX-23.01

EXHIBIT 23.01

Consent of Independent Registered Public Accounting Firm

The Board of Directors

Ambac Financial Group, Inc.:

We consent to the incorporation by reference in the registration statements (Nos. 333-43695 and 333-57206) on Form S-3, and in the registration statements (Nos. 33-47970, 33-63134, 33-47971, 33-44913 and 333-52449) on Form S-8 of Ambac Financial Group, Inc. of our reports dated March 2, 2005, with respect to the consolidated balance sheets of Ambac Financial Group, Inc. as of December 31, 2004 and 2003, and the related consolidated statements of operations, stockholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2004, and all related financial statement schedules, management’s assessment of the effectiveness of internal control over financial reporting as of December 31, 2004 and the effectiveness of internal control over financial reporting as of December 31, 2004, which reports appear in the December 31, 2004 Annual Report on Form 10-K of Ambac Financial Group, Inc. The aforementioned report with respect to the consolidated financial statements of Ambac Financial Group, Inc. refers to changes, in 2003, in Ambac Financial Group, Inc.’s methods of accounting for variable interest entities and stock-based compensation.

/s/ KPMG LLP

New York, New York

March 15, 2005

EX-24.01

EXHIBIT 24.01

AMBAC FINANCIAL GROUP, INC.

Power of Attorney

KNOW ALL MEN BY THESE PRESENTS that the undersigned director and officer of Ambac Financial Group, Inc., a Delaware corporation, hereby constitutes and appoints each of Thomas J. Gandolfo and Anne Gill Kelly, as his true and lawful attorney-in-fact and agent, with full power of substitution, for him and in his name, place and stead, in any and all capacities, to sign the Annual Report on Form 10-K for the year ended December 31, 2004, to be filed with the Securities and Exchange Commission and the New York Stock Exchange, and any and all amendments thereto, and any and all instruments and documents filed as a part of or in connection with the said Form 10-K or amendments thereto, and does hereby grant unto each said attorney-in-fact and agent full power and authority to do and perform each and every act and thing requisite and necessary to be done in and about the premises, as fully to all intents and purposes as he or she might or could do in person, hereby ratifying and confirming all that each said attorney-in-fact and agent shall do or cause to be done by virtue hereof.

IN WITNESS WHEREOF, the undersigned has subscribed these presents as of this 15th day of March, 2005.

/s/ Robert J. Genader

Robert J. Genader

EX-24.02

EXHIBIT 24.02

AMBAC FINANCIAL GROUP, INC.

Power of Attorney

KNOW ALL MEN BY THESE PRESENTS that the undersigned director of Ambac Financial Group, Inc., a Delaware corporation, hereby constitutes and appoints each of Thomas J. Gandolfo and Anne Gill Kelly, as his true and lawful attorney-in-fact and agent, with full power of substitution, for him and in his name, place and stead, in any and all capacities, to sign the Annual Report on Form 10-K for the year ended December 31, 2004, to be filed with the Securities and Exchange Commission and the New York Stock Exchange, and any and all amendments thereto, and any and all instruments and documents filed as a part of or in connection with the said Form 10-K or amendments thereto, and does hereby grant unto each said attorney-in-fact and agent full power and authority to do and perform each and every act and thing requisite and necessary to be done in and about the premises, as fully to all intents and purposes as he or she might or could do in person, hereby ratifying and confirming all that each said attorney-in-fact and agent shall do or cause to be done by virtue hereof.

IN WITNESS WHEREOF, the undersigned has subscribed these presents as of this 15th day of March, 2005.

/s/ Michael A. Callen

Michael A. Callen

EX-24.03

EXHIBIT 24.03

AMBAC FINANCIAL GROUP, INC.

Power of Attorney

KNOW ALL MEN BY THESE PRESENTS that the undersigned director of Ambac Financial Group, Inc., a Delaware corporation, hereby constitutes and appoints each of Thomas J. Gandolfo and Anne Gill Kelly, as his true and lawful attorney-in-fact and agent, with full power of substitution, for him and in his name, place and stead, in any and all capacities, to sign the Annual Report on Form 10-K for the year ended December 31, 2004, to be filed with the Securities and Exchange Commission and the New York Stock Exchange, and any and all amendments thereto, and any and all instruments and documents filed as a part of or in connection with the said Form 10-K or amendments thereto, and does hereby grant unto each said attorney-in-fact and agent full power and authority to do and perform each and every act and thing requisite and necessary to be done in and about the premises, as fully to all intents and purposes as he or she might or could do in person, hereby ratifying and confirming all that each said attorney-in-fact and agent shall do or cause to be done by virtue hereof.

IN WITNESS WHEREOF, the undersigned has subscribed these presents as of this 15th day of March, 2005.

/s/ Renso L. Caporali

Renso L. Caporali

EX-24.04

EXHIBIT 24.04

AMBAC FINANCIAL GROUP, INC.

Power of Attorney

KNOW ALL MEN BY THESE PRESENTS that the undersigned director of Ambac Financial Group, Inc., a Delaware corporation, hereby constitutes and appoints each of Thomas J. Gandolfo and Anne Gill Kelly, as her true and lawful attorney-in-fact and agent, with full power of substitution, for her and in her name, place and stead, in any and all capacities, to sign the Annual Report on Form 10-K for the year ended December 31, 2004, to be filed with the Securities and Exchange Commission and the New York Stock Exchange, and any and all amendments thereto, and any and all instruments and documents filed as a part of or in connection with the said Form 10-K or amendments thereto, and does hereby grant unto each said attorney-in-fact and agent full power and authority to do and perform each and every act and thing requisite and necessary to be done in and about the premises, as fully to all intents and purposes as he or she might or could do in person, hereby ratifying and confirming all that each said attorney-in-fact and agent shall do or cause to be done by virtue hereof.

IN WITNESS WHEREOF, the undersigned has subscribed these presents as of this 15th day of March, 2005.

/s/ Jill M. Considine

Jill M. Considine

EX-24.05

EXHIBIT 24.05

AMBAC FINANCIAL GROUP, INC.

Power of Attorney

KNOW ALL MEN BY THESE PRESENTS that the undersigned director of Ambac Financial Group, Inc., a Delaware corporation, hereby constitutes and appoints each of Thomas J. Gandolfo and Anne Gill Kelly, as his true and lawful attorney-in-fact and agent, with full power of substitution, for him and in his name, place and stead, in any and all capacities, to sign the Annual Report on Form 10-K for the year ended December 31, 2004, to be filed with the Securities and Exchange Commission and the New York Stock Exchange, and any and all amendments thereto, and any and all instruments and documents filed as a part of or in connection with the said Form 10-K or amendments thereto, and does hereby grant unto each said attorney-in-fact and agent full power and authority to do and perform each and every act and thing requisite and necessary to be done in and about the premises, as fully to all intents and purposes as he or she might or could do in person, hereby ratifying and confirming all that each said attorney-in-fact and agent shall do or cause to be done by virtue hereof.

IN WITNESS WHEREOF, the undersigned has subscribed these presents as of this 15th day of March, 2005.

/s/ Richard Dulude

Richard Dulude

EX-24.06

EXHIBIT 24.06

AMBAC FINANCIAL GROUP, INC.

Power of Attorney

KNOW ALL MEN BY THESE PRESENTS that the undersigned officer of Ambac Financial Group, Inc., a Delaware corporation, hereby constitutes and appoints each of Anne Gill Kelly and Kevin J. Doyle, as his true and lawful attorney-in-fact and agent, with full power of substitution, for him and in his name, place and stead, in any and all capacities, to sign the Annual Report on Form 10-K for the year ended December 31, 2004, to be filed with the Securities and Exchange Commission and the New York Stock Exchange, and any and all amendments thereto, and any and all instruments and documents filed as a part of or in connection with the said Form 10-K or amendments thereto, and does hereby grant unto each said attorney-in-fact and agent full power and authority to do and perform each and every act and thing requisite and necessary to be done in and about the premises, as fully to all intents and purposes as he or she might or could do in person, hereby ratifying and confirming all that each said attorney-in-fact and agent shall do or cause to be done by virtue hereof.

IN WITNESS WHEREOF, the undersigned has subscribed these presents as of this 15th day of March, 2005.

/s/ Thomas J. Gandolfo

Thomas J. Gandolfo

EX-24.07

EXHIBIT 24.07

AMBAC FINANCIAL GROUP, INC.

Power of Attorney

KNOW ALL MEN BY THESE PRESENTS that the undersigned director of Ambac Financial Group, Inc., a Delaware corporation, hereby constitutes and appoints each of Thomas J. Gandolfo and Anne Gill Kelly, as his true and lawful attorney-in-fact and agent, with full power of substitution, for him and in his name, place and stead, in any and all capacities, to sign the Annual Report on Form 10-K for the year ended December 31, 2004, to be filed with the Securities and Exchange Commission and the New York Stock Exchange, and any and all amendments thereto, and any and all instruments and documents filed as a part of or in connection with the said Form 10-K or amendments thereto, and does hereby grant unto each said attorney-in-fact and agent full power and authority to do and perform each and every act and thing requisite and necessary to be done in and about the premises, as fully to all intents and purposes as he or she might or could do in person, hereby ratifying and confirming all that each said attorney-in-fact and agent shall do or cause to be done by virtue hereof.

IN WITNESS WHEREOF, the undersigned has subscribed these presents as of this 15th day of March, 2005.

/s/ W. Grant Gregory

W. Grant Gregory

EX-24.08

EXHIBIT 24.08

AMBAC FINANCIAL GROUP, INC.

Power of Attorney

KNOW ALL MEN BY THESE PRESENTS that the undersigned director and officer of Ambac Financial Group, Inc., a Delaware corporation, hereby constitutes and appoints each of Thomas J. Gandolfo and Anne Gill Kelly, as his true and lawful attorney-in-fact and agent, with full power of substitution, for him and in his name, place and stead, in any and all capacities, to sign the Annual Report on Form 10-K for the year ended December 31, 2004, to be filed with the Securities and Exchange Commission and the New York Stock Exchange, and any and all amendments thereto, and any and all instruments and documents filed as a part of or in connection with the said Form 10-K or amendments thereto, and does hereby grant unto each said attorney-in-fact and agent full power and authority to do and perform each and every act and thing requisite and necessary to be done in and about the premises, as fully to all intents and purposes as he or she might or could do in person, hereby ratifying and confirming all that each said attorney-in-fact and agent shall do or cause to be done by virtue hereof.

IN WITNESS WHEREOF, the undersigned has subscribed these presents as of this 15th day of March, 2005.

/s/ Phillip B. Lassiter

Phillip B. Lassiter

EX-24.09

EXHIBIT 24.09

AMBAC FINANCIAL GROUP, INC.

Power of Attorney

KNOW ALL MEN BY THESE PRESENTS that the undersigned director of Ambac Financial Group, Inc., a Delaware corporation, hereby constitutes and appoints each of Thomas J. Gandolfo and Anne Gill Kelly, as his true and lawful attorney-in-fact and agent, with full power of substitution, for him and in his name, place and stead, in any and all capacities, to sign the Annual Report on Form 10-K for the year ended December 31, 2004, to be filed with the Securities and Exchange Commission and the New York Stock Exchange, and any and all amendments thereto, and any and all instruments and documents filed as a part of or in connection with the said Form 10-K or amendments thereto, and does hereby grant unto each said attorney-in-fact and agent full power and authority to do and perform each and every act and thing requisite and necessary to be done in and about the premises, as fully to all intents and purposes as he or she might or could do in person, hereby ratifying and confirming all that each said attorney-in-fact and agent shall do or cause to be done by virtue hereof.

IN WITNESS WHEREOF, the undersigned has subscribed these presents as of this 15th day of March, 2005.

/s/ Thomas C. Theobald

Thomas C. Theobald

EX-24.10

EXHIBIT 24.10

AMBAC FINANCIAL GROUP, INC.

Power of Attorney

KNOW ALL MEN BY THESE PRESENTS that the undersigned director of Ambac Financial Group, Inc., a Delaware corporation, hereby constitutes and appoints each of Thomas J. Gandolfo and Anne Gill Kelly, as her true and lawful attorney-in-fact and agent, with full power of substitution, for her and in her name, place and stead, in any and all capacities, to sign the Annual Report on Form 10-K for the year ended December 31, 2004, to be filed with the Securities and Exchange Commission and the New York Stock Exchange, and any and all amendments thereto, and any and all instruments and documents filed as a part of or in connection with the said Form 10-K or amendments thereto, and does hereby grant unto each said attorney-in-fact and agent full power and authority to do and perform each and every act and thing requisite and necessary to be done in and about the premises, as fully to all intents and purposes as he or she might or could do in person, hereby ratifying and confirming all that each said attorney-in-fact and agent shall do or cause to be done by virtue hereof.

IN WITNESS WHEREOF, the undersigned has subscribed these presents as of this 15th day of March, 2005.

/s/ Laura S. Unger

Laura S. Unger

EX-24.11

EXHIBIT 24.11

AMBAC FINANCIAL GROUP, INC.

Power of Attorney

KNOW ALL MEN BY THESE PRESENTS that the undersigned director of Ambac Financial Group, Inc., a Delaware corporation, hereby constitutes and appoints each of Thomas J. Gandolfo and Anne Gill Kelly, as his true and lawful attorney-in-fact and agent, with full power of substitution, for him and in his name, place and stead, in any and all capacities, to sign the Annual Report on Form 10-K for the year ended December 31, 2004, to be filed with the Securities and Exchange Commission and the New York Stock Exchange, and any and all amendments thereto, and any and all instruments and documents filed as a part of or in connection with the said Form 10-K or amendments thereto, and does hereby grant unto each said attorney-in-fact and agent full power and authority to do and perform each and every act and thing requisite and necessary to be done in and about the premises, as fully to all intents and purposes as he or she might or could do in person, hereby ratifying and confirming all that each said attorney-in-fact and agent shall do or cause to be done by virtue hereof.

IN WITNESS WHEREOF, the undersigned has subscribed these presents as of this 15th day of March, 2005.

/s/ Henry D. G. Wallace

Henry D. G. Wallace

EX-31.1

EXHIBIT 31.1

Ambac Financial Group, Inc.

Certifications

I, Robert J. Genader, certify that:

1. I have reviewed this annual report on Form 10-K of Ambac Financial Group, Inc;

2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

4. The registrant’s other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a - -15(e) and 15d – 15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have:

a. Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

b. Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;

c. Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

d. Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

5. The registrant’s other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent function):

a. All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

b. Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

	By:	/s/ Robert J. Genader
		Robert J. Genader
		Chief Executive Officer and President
Date: March 15, 2005

EX-31.2

EXHIBIT 31.2

Ambac Financial Group, Inc.

Certifications

I, Thomas J. Gandolfo, certify that:

1. I have reviewed this annual report on Form 10-K of Ambac Financial Group, Inc;

2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

4. The registrant’s other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a - -15(e) and 15d – 15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have:

a. Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

b. Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;

c. Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

d. Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

5. The registrant’s other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent function):

a. All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

b. Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

	By:	/s/ Thomas J. Gandolfo
		Thomas J. Gandolfo
		Senior Vice President and Chief Financial Officer
Date: March 15, 2005

EX-32.1

EXHIBIT 32.1

Certification of CEO Pursuant to

18 U.S.C. Section 1350,

as Adopted Pursuant to

Section 906 of the Sarbanes-Oxley Act of 2002

In connection with the Annual Report on Form 10-K of Ambac Financial Group, Inc. (the “Company”) for the period ended December 31, 2004, as filed with the Securities and Exchange Commission on the date hereof (the “Report”), Robert J. Genader, as Chief Executive Officer of the Company, hereby certifies, pursuant to 18 U.S.C. § 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that, to the best of his knowledge:

(1) The Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and

(2) The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.

/s/ Robert J. Genader
Name:	Robert J. Genader
Title:	Chief Executive Officer and President
Date:	March 15, 2005

EX-32.2

EXHIBIT 32.2

Certification of CFO Pursuant to

18 U.S.C. Section 1350,

as Adopted Pursuant to

Section 906 of the Sarbanes-Oxley Act of 2002

In connection with the Annual Report on Form 10-K of Ambac Financial Group, Inc. (the “Company”) for the period ended December 31, 2004, as filed with the Securities and Exchange Commission on the date hereof (the “Report”), Thomas J. Gandolfo, as Chief Financial Officer of the Company, hereby certifies, pursuant to 18 U.S.C. § 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that, to the best of his knowledge:

(1) The Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and

(2) The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.

/s/ Thomas J. Gandolfo
Name:	Thomas J. Gandolfo
Title:	Senior Vice President and Chief Financial Officer
Date:	March 15, 2005

EX-99.01

EXHIBIT 99.01

AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES

(a wholly-owned subsidiary of Ambac Financial Group, Inc.)

Consolidated Financial Statements

December 31, 2004 and 2003

Report of Independent Registered Public Accounting Firm

The Board of Directors

Ambac Assurance Corporation:

We have audited the accompanying consolidated balance sheets of Ambac Assurance Corporation and subsidiaries (a wholly owned subsidiary of Ambac Financial Group, Inc.) as of December 31, 2004 and 2003, and the related consolidated statements of operations, stockholder’s equity and cash flows for each of the years in the three-year period ended December 31, 2004. These consolidated financial statements are the responsibility of Ambac Assurance Corporation’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Ambac Assurance Corporation and subsidiaries as of December 31, 2004 and 2003, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2004, in conformity with U.S. generally accepted accounting principles.

As discussed in Note 2 to the consolidated financial statements, in 2003 Ambac Assurance Corporation changed its methods of accounting for variable interest entities and stock-based compensation.

/s/ KPMG LLP

New York, New York

March 2, 2005

AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES

Consolidated Balance Sheets

December 31, 2004 and 2003

(Dollars in Thousands Except Share Data)

	2004		2003
ASSETS
Investments:
Fixed income securities, at fair value (amortized cost of $8,082,790 in 2004 and $7,197,960 in 2003)	$	8,437,694	$	7,567,442
Short-term investments, at cost (approximates fair value)		484,232		213,716
Other, (cost of $3,271 in 2004 and $3,508 in 2003)		3,426		3,311
Total investments		8,925,352		7,784,469
Cash		17,360		18,350
Securities purchased under agreements to resell		52,000		138,795
Receivable for securities sold		308		81
Investment income due and accrued		105,407		98,830
Reinsurance recoverable on paid and unpaid losses		16,765		3,030
Prepaid reinsurance		297,330		325,461
Deferred acquisition costs		184,766		175,296
Derivative assets		1,297,972		1,146,408
Loans		730,865		—
Other assets		68,111		42,516
Total assets	$	11,696,236	$	9,733,236
LIABILITIES AND STOCKHOLDER’S EQUITY
Liabilities:
Unearned premiums	$	2,782,768	$	2,553,214
Losses and loss expense reserve		254,055		189,414
Ceded reinsurance balances payable		18,248		15,383
Obligations under payment agreements		249,140		249,810
Deferred income taxes		256,384		232,790
Current income taxes		26,559		38,972
Long-term debt		1,074,368		189,151
Notes payable to affiliate		—		84,280
Payable for securities purchased		—		2,830
Derivative liabilities		1,206,740		1,088,126
Other liabilities		181,260		190,081
Total liabilities		6,049,522		4,834,051
Stockholder’s equity:
Preferred stock, par value $1,000 per share; authorized shares — 285,000; issued and outstanding shares — none		—		—
Common stock, par value $2.50 per share; authorized shares — 40,000,000; issued and outstanding shares — 32,800,000 at December 31, 2004 and December 31, 2003		82,000		82,000
Additional paid-in capital		1,232,701		1,144,096
Accumulated other comprehensive income		237,632		243,053
Retained earnings		4,094,381		3,430,036
Total stockholder’s equity		5,646,714		4,899,185
Total liabilities and stockholder’s equity	$	11,696,236	$	9,733,236

See accompanying Notes to Consolidated Financial Statements.

1

AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES

Consolidated Statements of Operations

(Dollars in Thousands)

	Years Ended December 31,
	2004			2003			2002
Revenues:
Financial Guarantee:
Gross premiums written	$	1,050,214		$	1,149,172		$	908,890
Ceded premiums written		(70,946	)		(138,146	)		(113,542	)
Net premiums written	$	979,268		$	1,011,026		$	795,348
Net premiums earned	$	722,911		$	626,673		$	477,592
Other credit enhancement fees		47,326			46,933			28,775
Net premiums earned and other credit enhancement fees		770,237			673,606			506,367
Net investment income		361,086			321,089			297,266
Net realized investment gains		30,004			40,190			40,918
Net mark-to-market gains (losses) on credit derivative contracts		17,734			23			(27,877	)
Other income		6,601			4,927			4,996
Financial Services:
Interest from payment agreements		12,059			12,061			—
Other revenue		35,568			20,799			18,502
Total revenues		1,233,289			1,072,695			840,172
Expenses:
Financial Guarantee:
Losses and loss expenses		69,600			53,400			26,700
Underwriting and operating expenses		106,563			92,603			76,804
Interest expense		5,295			386			2,035
Financial Services:
Interest from payment agreements		3,752			3,503			—
Other expenses		6,889			6,706			5,256
Total expenses		192,099			156,598			110,795
Income before income taxes		1,041,190			916,097			729,377
Income tax expense (benefit):
Current taxes		245,423			249,359			184,010
Deferred taxes		28,422			(4,417	)		4,959
Total income taxes		273,845			244,942			188,969
Net income	$	767,345		$	671,155		$	540,408

See accompanying Notes to Consolidated Financial Statements.

2

AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES

Consolidated Statements of Stockholder’s Equity

(Dollars In Thousands)

	Years Ended December 31,
	2004						2003					2002
Retained Earnings:
Balance at January 1	$	3,430,036					$	2,848,481				$	2,386,073
Net income		767,345		$	767,345			671,155		$	671,155		540,408		$	540,408
Dividends declared – common stock		(103,000	)					(89,600	)				(78,000	)
Balance at December 31	$	4,094,381					$	3,430,036				$	2,848,481
Accumulated Other Comprehensive Income (Loss):
Balance at January 1	$	243,053					$	231,436				$	80,556
Unrealized gains (losses) on securities, $(14,005), $12,710, and $229,078, pre-tax, in 2004, 2003 and 2002, respectively) (1)					(9,098	)					8,268					148,901
Loss on derivative hedges					—						—					(200	)
Foreign currency gain					3,677						3,349					2,179
Other comprehensive (loss) income		(5,421	)		(5,421	)		11,617			11,617		150,880			150,880
Total comprehensive income				$	761,924					$	682,772				$	691,288
Balance at December 31	$	237,632					$	243,053				$	231,436
Common Stock:
Balance at January 1 and December 31	$	82,000					$	82,000				$	82,000
Additional Paid-in Capital:
Balance at January 1	$	1,144,096					$	920,146				$	928,094
Capital contribution		62,606						210,384					—
Capital issuance costs		(4,698	)					(4,671	)				(8,453	)
Employee benefit plans		30,697						18,237					505
Balance at December 31	$	1,232,701					$	1,144,096				$	920,146
Total Stockholder’s Equity at December 31	$	5,646,714					$	4,899,185				$	4,082,063

⁽¹⁾ Disclosure of reclassification amount:

	2004			2003		2002
Unrealized holding gains arising during period	$	9,863		$	34,102	$	174,295
Less: reclassification adjustment for net gains included in net income		18,961			25,834		25,394
Net unrealized (losses) gains on securities	$	(9,098	)	$	8,268	$	148,901

See accompanying Notes to Consolidated Financial Statements.

3

AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES

Consolidated Statements of Cash Flows

(Dollars in Thousands)

	Years Ended December 31,
	2004			2003			2002
Cash flows from operating activities:
Net income	$	767,345		$	671,155		$	540,408
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		2,744			2,765			2,881
Amortization of bond premium and discount		9,903			3,215			(4,685	)
Current income taxes		3,944			9,497			(84,159	)
Deferred income taxes		28,496			(3,933	)		4,557
Deferred acquisition costs		(9,470	)		(1,241	)		(10,578	)
Unearned premiums, net		257,685			386,419			318,905
Losses and loss expenses		50,906			19,089			17,202
Ceded reinsurance balances payable		2,865			(1,547	)		6,784
Net realized investment gains		(30,004	)		(40,190	)		(40,918	)
Other, net		(73,327	)		8,315			(4,733	)
Net cash provided by operating activities		1,011,087			1,053,544			745,664
Cash flows from investing activities:
Proceeds from sales of bonds		1,534,720			1,135,858			1,228,101
Proceeds from matured bonds		424,911			684,546			316,822
Purchases of bonds		(2,822,731	)		(2,882,213	)		(2,363,358	)
Loans		(730,865	)		—			—
Change in short-term investments		(270,516	)		73,599			(101,372	)
Securities purchased under agreements to resell		86,795			(81,042	)		(6,003	)
Other, net		(5,628	)		(10,005	)		2,162
Net cash used in investing activities		(1,783,314	)		(1,079,257	)		(923,648	)
Cash flows from financing activities:
Dividends paid		(103,000	)		(89,600	)		(78,000	)
Capital contributions		62,606			103,224			—
Proceeds from issuance of long-term debt		885,217			—			—
Capital issuance costs		(4,698	)		(4,671	)		(8,452	)
Payment agreements		(670	)		(724	)		250,534
Net cash collateral received		16,062			47,028			—
Long-term financing from affiliates		—			(47,100	)		(3,900	)
Short-term financing from affiliates		(84,280	)		20,030			—
Net cash provided by financing activities		771,237			28,187			160,182
Net cash flow		(990	)		2,474			(17,802	)
Cash at January 1		18,350			15,876			33,678
Cash at December 31	$	17,360		$	18,350		$	15,876
Supplemental disclosure of cash flow information:
Cash paid during the year for:
Income taxes	$	201,333		$	199,648		$	206,833
Interest on affiliate financings	$	151		$	386		$	1,139
Interest on payment agreements	$	3,082		$	2,778		$	—
Interest on long-term debt	$	3,057		$	—		$	—

Supplemental disclosure of non-cash financing activities:

Ambac Assurance received capital contributions from its parent company in December 2003 in the form of fixed income securities amounting to $107,160.

See accompanying Notes to Consolidated Financial Statements.

4

AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollar Amounts in Thousands)

1 BACKGROUND

Ambac Assurance Corporation is a leading provider of financial guarantees to clients in both the public and private sectors around the world. Ambac Assurance provides financial guarantees on public finance and structured finance obligations. Ambac Assurance has earned triple-A ratings, the highest ratings available from Moody’s Investors Service, Inc., Standard & Poor’s Ratings Services, Fitch, Inc., and Rating and Investment Information, Inc. Ambac Assurance is a wholly owned subsidiary of Ambac Financial Group, Inc. (“Ambac Financial Group”), a holding company whose subsidiaries provide financial guarantees and financial services to clients in both the public and private sectors around the world.

2 SIGNIFICANT ACCOUNTING POLICIES

The accompanying consolidated financial statements of Ambac Assurance and subsidiaries have been prepared on the basis of U.S. generally accepted accounting principles (“GAAP”). The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the consolidated financial statements and the reported revenues and expenses during the reporting period. Actual results could differ from those estimates. The significant accounting policies of Ambac Assurance are as described below:

CONSOLIDATION:

The consolidated financial statements include the accounts of Ambac and its subsidiaries and variable interest entities for which Ambac is the primary beneficiary. All significant intercompany balances have been eliminated.

INVESTMENTS:

Ambac Assurance’s investment portfolio is accounted for on a trade-date basis and consists primarily of investments in fixed income securities that are considered available-for-sale and are carried at fair value. Fair value is based primarily on quotes obtained from independent market sources. When quotes are not available, valuation models are used to estimate fair value. These models include estimates, made by management, which utilize current market information. The valuation results from these models could differ materially from amounts that would actually be realized in the market. Short-term investments are carried at cost, which approximates fair value. Unrealized gains and losses, net of deferred income taxes, are included as a component of “Accumulated Other Comprehensive Income” in stockholder’s equity and are computed using amortized cost as the basis. If management believes that an unrealized loss is “other than temporary”, the carrying value of the investment is reduced and a realized investment loss is recorded in the Consolidated Statement of Operations. For purposes of computing amortized cost, premiums and discounts are accounted for using the interest method. For bonds purchased at a price below par value, discounts are accreted over the remaining term of the securities. For bonds purchased at a price above par value which have call features, premiums are amortized to the first call date. For premium bonds that do not have call features, such premiums are amortized over the remaining terms of the securities. Premiums and discounts on mortgage-backed and asset-backed securities are adjusted for the effects of actual and anticipated prepayments. Realized gains and losses on the sale of investments are determined on the basis of specific identification.

5

AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollar Amounts in Thousands)

SECURITIES PURCHASED UNDER AGREEMENTS TO RESELL:

Securities purchased under agreements to resell are collateralized investment transactions, and are recorded at their contracted resale amounts, plus accrued interest. Ambac Assurance takes possession of the collateral underlying those agreements and monitors its market value on a daily basis and, when necessary, requires prompt transfer of additional collateral to reflect current market value. At December 31, 2004 and 2003, collateral underlying securities purchased under agreements to resell had an average credit rating of triple-A and a weighted average maturity of less than 30 days and less than 90 days, respectively.

DEFERRED ACQUISITION COSTS:

Certain financial guarantee costs incurred, primarily related to the production of business, have been deferred. These costs include direct and indirect expenses related to underwriting, marketing and policy issuance, rating agency fees and premium taxes, net of reinsurance ceding commissions. The deferred acquisition costs are being amortized over the periods in which the related premiums are earned, and such amortization amounted to $25,260, $38,529 and $32,336 for 2004, 2003 and 2002, respectively. Deferred acquisition costs, net of such amortization, amounted to $9,470, $1,241 and $10,578 for 2004, 2003 and 2002, respectively.

LOANS:

Loans are reported at their outstanding principal balances. Interest income is accrued on the unpaid principal balance.

LOSSES AND LOSS EXPENSES:

Ambac Assurance provides financial guarantee insurance on certain debt obligations. This financial guarantee insurance is a promise to pay scheduled interest and principal if the issuer of the debt security fails to meet its obligation. The loss reserve policy for financial guarantee insurance discussed in this footnote relates only to Ambac Assurance’s non-derivative insurance business. The policy for derivative contracts is discussed in the section entitled “Derivative Contracts”. Losses and loss expenses are based upon estimates of the ultimate aggregate losses inherent in the non-derivative financial guarantee portfolio as of the reporting date. The evaluation process for determining the level of reserves is subject to certain estimates and judgments. In most instances, claim payments are forecasted in advance of issuer default as a result of active surveillance of the insured book of business. Based upon Ambac Assurance experience, claim payments become probable and estimable once the issuer’s credit profile has migrated to certain impaired credit levels. The insured party has the right to a claim under Ambac Assurance’s financial guarantee insurance policy at the first scheduled debt service date of the defaulted obligation. As discussed below, the accounting for credit loss reserves is possibly subject to change.

The liability for losses and loss expenses consists of active credit and case basis credit reserves. Active credit reserves are for probable and estimable losses due to credit deterioration on insured credits that have not yet defaulted or been reported and are reflected on an undiscounted basis as of the reporting date. The establishment of reserves for exposures that have not yet defaulted is a common practice in the financial guarantee industry. However, Ambac Assurance is aware that there are differences in the specific methodologies applied by other financial guarantors in establishing such reserves. Ambac

6

AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollar Amounts in Thousands)

Assurance’s active credit reserve is based on management’s on-going review of the non-derivative financial guarantee credit portfolio. Active surveillance of the insured portfolio enables Ambac Assurance’s Surveillance Group to track credit migration of insured obligations from period to period and prepare an adversely classified credit listing. The active credit reserve is established only for adversely classified credits. The criteria for an exposure to be included on the adversely classified credit listing includes the deterioration in an issuer’s financial condition, underperformance of the underlying collateral (for collateral dependent transactions such as mortgage-backed securitizations), problems with the servicer of the underlying collateral and other adverse economic events or trends. The servicer of the underlying collateral of a securitized credit is a consideration in assessing credit quality because the servicer’s performance can directly impact the performance of the related credit. For example, a servicer of a mortgage-backed securitization that does not remain current in their collection efforts could cause an increase in the delinquency and potential default of the underlying collateral. The active credit reserve is established through a process that begins with statistical estimates of probable losses inherent in the adversely classified credit portfolio. Statistical estimates are computed on each adversely classified credit. These statistical estimates are based upon: (i) Ambac Assurance’s internal system of credit ratings, which are analogous to the risk ratings of the major rating agencies; (ii) internally developed historical default information (taking into consideration ratings and average life of an obligation); (iii) internally developed loss severities; and (iv) the net par outstanding on the adversely classified credit. The loss severities and default information are based on rating agency information and are specific to each bond type and are established and approved by Ambac Assurance’s Portfolio Risk Management Committee. The Portfolio Risk Management Committee is comprised of senior risk management professionals and other senior management of Ambac Assurance. For certain credit exposures that have deteriorated significantly, Ambac will undertake additional monitoring and loss remediation efforts. Additional remediation can include various actions by Ambac Assurance. The most common actions include obtaining detailed appraisal information on collateral, more frequent meetings with the issuer’s or servicer’s management to review operations, financial condition and financial forecasts and more frequent analysis of the issuer’s financial statements. For these credits management would use relevant information obtained from its remediation efforts to adjust the statistical estimate discussed above. Senior management meets at least quarterly with the Surveillance Group to review the status of their work to determine the adequacy of Ambac Assurance’s loss reserves and make any necessary adjustments. Active credit reserves were $120,802 and $132,181 at December 31, 2004 and 2003, respectively. The active credit reserves at December 31, 2004 and 2003 was comprised of 68 and 60 credits with net par outstanding of $7,574,223 and $3,705,103, respectively. Included in the calculation of active credit reserves at December 31, 2004 and 2003 was the consideration of $17,891 and $38,592, respectively, of reinsurance which would be due to Ambac Assurance from the reinsurers, upon default of the insured obligation.

Case basis credit reserves are for losses on insured obligations that have defaulted. We believe our definition of case basis credit reserves differs from other financial guaranty industry participants. Upon the occurrence of a payment default, the related active credit reserve is transferred to case basis credit reserve. Additional provision for losses upon further credit deterioration of a case basis exposure are initially recorded through the active credit reserve and subsequently transferred to case basis credit reserves. Our case reserves represent the present value of anticipated loss and loss expense payments expected over the estimated period of default. Loss and loss expenses consider anticipated defaulted debt service payments, estimated expenses associated with settling the claims and estimated recoveries under collateral and subrogation rights. The estimate does not consider future installment premium receipts, as the likelihood of such receipts is remote. Ambac Assurance discounts these estimated net payments using discount rates that approximate the average taxable equivalent yield on our investment

7

AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollar Amounts in Thousands)

portfolio. Discount rates applied to case basis credit reserves were 6.0% and 6.5% at December 31, 2004 and 2003, respectively. Case basis credit reserves were $133,254 and $57,234 at December 31, 2004 and 2003, respectively. The case basis credit reserves at December 31, 2004 and 2003 was comprised of 11 and 10 credits with net par outstanding of $661,396 and $709,278, respectively. Additionally, we have reinsurance recoverables on case basis credit reserves of $16,499 and $2,535 at December 31, 2004 and 2003, respectively.

Ambac Assurance provides information on the classification of its loss reserve between active credit reserve and case basis credit reserve for the purpose of disclosing the components of the total reserve that relate to exposures that have not yet defaulted and those that have defaulted. The total reserve (active credit and case basis) was $254,055 and $189,414 at December 31, 2004 and 2003, respectively. The provision for losses and loss expenses in the accompanying Consolidated Statements of Operations represents the expense recorded to bring the total reserve to a level determined by management to be adequate for losses inherent in the non-derivative financial guaranty insurance portfolio.

Our liabilities for credit losses are based in part on the short-duration accounting guidance in Statement of Financial Accounting Standards (“SFAS”) No. 60, “Accounting and Reporting by Insurance Enterprises.” The insured party has a right to a claim payment under the financial guaranty insurance policy at the date of the first scheduled debt service payment of a defaulted security. We believe a loss event occurs for financial guarantee insurance products at the time the issuers’ financial condition deteriorates to an impaired credit status rather than at the time the insured party has a right to a claim payment. Because of this belief and the ambiguities discussed below in the application of SFAS No. 60 to the financial guaranty industry, Ambac Assurance does not believe that SFAS No. 60 alone provides sufficient guidance. As a result, Ambac Assurance supplements the guidance in SFAS No. 60 with the guidance in SFAS No. 5, “Accounting for Contingencies,” which calls for a loss to be accrued if it is probable that a liability has been incurred at the date of the financial statements and the amount of loss can be reasonably estimated. Ambac Assurance also relies by analogy on EITF Issue No. 85-20, “Recognition of Fees for Guaranteeing a Loan,” which states that a guarantor should perform an ongoing assessment of the probability of loss to determine if a liability (and a loss) should be recognized under SFAS No. 5.

In management’s view, the accounting guidance noted above does not comprehensively address the attributes of financial guarantee insurance contracts, primarily due to the fact that SFAS No. 60 was developed prior to the maturity of the financial guarantee industry. Financial guarantee contracts have elements of long-duration insurance contacts in that they are irrevocable and extend over a period of time that may be 30 years or more but are considered and reported for regulatory purposes as property and casualty insurance, normally considered short-duration contracts. The short-duration and long-duration classifications have different methods of accounting for premium revenue, deferred acquisition costs and contract liability recognition.

Ambac Assurance is aware that there are certain differences regarding the measurement of liabilities for credit losses among participants in the financial guaranty industry. Difficulties applying the existing insurance accounting literature such as the classification of the insurance contracts as either short-duration or long-duration to the attributes of financial guarantee insurance, different measurement models and assumptions utilized, regulatory guidance provided to certain entities, and the existence of accounting literature providing guidance with respect to liability recognition for loan guarantees are the reasons for differences amongst the industry participants.

8

AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollar Amounts in Thousands)

In January and February of 2005, the Securities and Exchange Commission (“SEC”) staff discussed with financial guaranty industry participants differences in loss reserve recognition practices among those participants. Based on discussions with the SEC staff, Ambac Assurance understands the FASB staff is considering whether additional guidance regarding financial guarantee contracts should be provided. When and if the FASB or SEC reach a conclusion on this issue, Ambac Assurance and the rest of the financial guaranty industry may be required to change some aspects of their loss reserving policies and the potential changes could extend to premium and expense recognition. Ambac Assurance cannot predict how the FASB or SEC will resolve this issue and the resulting impact on our financial statements. Until the issue is resolved, Ambac Assurance intends to continue to apply its existing policy with respect to the establishment of both case and active credit reserves.

OBLIGATIONS UNDER PAYMENT AGREEMENTS:

Ambac Assurance has obligations under certain payment agreements that represent funds received from various investors and used to purchase fixed income municipal investment securities. Obligations under payment agreements are recorded as liabilities on the Consolidated Balance Sheets at the face value of the agreement. Interest expense is computed based upon daily outstanding settled liabilities balances, at rates and periods specified in the agreements. Net interest income related to payment agreements is included as a component of Financial Services revenue. Under the terms of these payment agreements the investors have the contractual right to redeem their investment at any time, within five business days notice to Ambac Assurance.

NET PREMIUMS EARNED:

Up-front insurance premiums written are received for an entire bond issue. A bond issue may contain several maturities. The premium is allocated to each bond maturity proportionally, based on total principal amount guaranteed and is recognized on a straight-line basis over the term of each maturity. Installment insurance premiums written are recognized over each installment period. When an issue insured by Ambac Assurance has been refunded or called, the remaining unrecognized premium (net of refunding credits, if any) is recognized at that time.

FINANCIAL SERVICES REVENUE:

Ambac Assurance provides interest rate swaps principally to states, municipalities and municipal authorities in connection with their financings. Ambac Assurance also enters into total return swaps with various financial institutions. All interest rate swaps and total return swap revenues are accounted for as “Derivative Contracts Classified as Held for Trading Purposes,” which is discussed in the Derivative Contracts section below.

DERIVATIVE CONTRACTS CLASSIFIED AS HELD FOR TRADING PURPOSES:

All derivative instruments are recognized in the Consolidated Balance Sheets as either assets or liabilities depending on the rights or obligations under the contracts. All derivative instruments are measured at estimated fair value. When available, quotes are obtained from independent market sources. However, when quotes are not available, Ambac uses internally developed valuation models. These valuation models require market driven inputs, including contractual terms, credit spreads on underlying referenced obligations, yield curves and tax-exempt interest ratios. The valuation results from these

9

AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollar Amounts in Thousands)

models could differ materially from amounts that would actually be realized in the market. At the inception of a derivative contract (day one), we value the contract at the model value if we can verify all of the significant model inputs to observable market data. Where we cannot verify all of the significant model inputs to observable market data, we value the contract at the transaction price at inception and, consequently, record no gain or loss in accordance with EITF Issue No. 02-3, “Issues Involved in Accounting for Derivative Contracts Held for Trading Purposes and Contracts Involved in Energy Trading and Risk Management Activities.”

All derivative contracts are recorded on the Consolidated Balance Sheets on a gross basis; assets and liabilities are netted by customer only when a legal right of set-off exists. Gross asset and gross liability balances for all derivatives are recorded as Derivative Assets or Derivative Liabilities on the Consolidated Balance Sheets.

Credit Derivatives:

Ambac Assurance, through its subsidiary Ambac Credit Products, enters into structured credit derivative transactions with various financial institutions. Management views these structured credit derivative transactions as an extension of its financial guarantee business, which the Company intends to hold for the entire term of the contract. These structured credit derivative contracts are accounted for at fair value since they do not qualify for the financial guarantee scope exception under SFAS 133, as amended. Changes in fair value are recorded in the Consolidated Statement of Operations. The fee component is reflected in “Other Credit Enhancement Fees” and the mark-to-market gains or losses associated with credit spread changes is reflected in “Net Mark-to-Market Gains (Losses) on Credit Derivative Contracts”.

Financial Services:

Ambac Assurance, through its subsidiary Ambac Financial Services, provides interest rate swaps to states, municipalities and their authorities, and other entities in connection with their financings. Ambac Capital Services enters into total return swaps with professional counterparties. Total return swaps are primarily used for fixed income obligations, which meet Ambac Assurance’s credit underwriting criteria. These contracts are recorded on trade date at fair value. Changes in fair value are recorded as a component of “Other Revenues” in the accompanying Consolidated Statements of Operations.

DEPRECIATION AND AMORTIZATION:

Depreciation of furniture and fixtures and electronic data processing equipment is provided over the estimated useful lives of the respective assets, ranging from three to five years, using the straight-line method. Amortization of leasehold improvements is charged over the lesser of the remaining term of the operating leases, or ten years, using the straight-line method.

POSTRETIREMENT AND POSTEMPLOYMENT BENEFITS:

Ambac Financial Group’s various postretirement and postemployment benefits, including pension and health and life benefits cover substantially all employees who meet certain age and service requirements. Ambac Assurance accounts for these benefits under the accrual method of accounting. Amounts related to the defined benefit pension plan and postretirement health benefits are charged based on actuarial determinations.

10

AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollar Amounts in Thousands)

STOCK COMPENSATION PLANS:

Ambac Financial Group sponsors the “1997 Equity Plan”, where awards are granted to eligible employees in the form of non-qualified stock options or other stock-based awards. Effective January 1, 2003, Ambac Assurance began to account for stock-based employee compensation in accordance with the fair-value method prescribed by SFAS Statement 123, “Accounting for Stock-Based Compensation,” (“SFAS 123”) as amended by SFAS Statement 148, “Accounting for Stock-Based Compensation – Transition and Disclosure,” (“SFAS 148”), prospectively to all employee awards granted after January 1, 2003. Under this method of adoption, compensation expense is recognized over the relevant service period based on the fair value of stock options and restricted stock units granted for 2003 and future years. No unearned compensation is included in “Stockholders’ Equity” for such stock options and restricted stock units granted. Rather, such stock options and restricted stock units are included in “Stockholders’ Equity” under SFAS 123 when services required from employees in exchange for the awards are rendered and expensed. Compensation expense resulting from stock options and restricted stock units granted for the years ended December 31, 2002 and prior years is accounted for under the intrinsic-value based method prescribed by APB Opinion No. 25, “Accounting for Stock Issued to Employees,” as permitted by SFAS 123. Therefore, no compensation expense was recognized for stock options issued for years prior to 2003 that had no intrinsic value on the date of grant. Compensation expense for restricted stock units issued for the years prior to 2003 was, and continues to be, recognized over the relevant service periods using amortization schedules based on the applicable vesting provisions.

FOREIGN CURRENCY:

Financial statement accounts expressed in foreign currencies are translated into U.S. dollars in accordance with SFAS Statement 52, “Foreign Currency Translation” (“SFAS 52”). Under SFAS 52, functional currency assets and liabilities are translated into U.S. dollars using exchange rates in effect at the balance sheet dates and the related translation adjustments are included as a component of “Accumulated Other Comprehensive Income”, net of any related taxes in Stockholders’ Equity. Functional currencies are generally the currencies of the local operating environment. Income statement accounts expressed in functional currencies are translated using average exchange rates. Foreign currency transaction gains and losses, arising primarily from sales of long-term foreign denominated investment securities, short-term investment securities and cash denominated in foreign currencies, are reflected in net income. The Consolidated Statements of Operations include pre-tax gains from such foreign exchange items of $6,596, $9,511 and $1,820 for 2004, 2003 and 2002, respectively.

INCOME TAXES:

Pursuant to a tax sharing agreement, Ambac Assurance is included in Ambac Financial Group, Inc.’s consolidated Federal income tax return. The tax sharing agreement provides for the determination of tax expense or benefit based on the contribution of Ambac Assurance to Ambac Financial Group’s consolidated Federal income tax liability, computed substantially as if Ambac Assurance filed a separate Federal income tax return. The tax liability due is settled quarterly, with a final settlement taking place after the filing of the consolidated Federal income tax return. Ambac Assurance files its own state income tax returns.

11

AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollar Amounts in Thousands)

Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in the period that includes the enactment date.

SPECIAL PURPOSE AND VARIABLE INTEREST ENTITIES:

In January 2003, the FASB released FASB Interpretation No. 46 “Consolidation of Variable Interest Entities” (“FIN 46”). In December 2003, the FASB released a revision of FIN 46 (“FIN 46-R”), which includes substantial changes from the original FIN 46. FIN 46 and FIN 46-R provide accounting and disclosure rules for determining whether certain entities should be consolidated in Ambac Assurance’s consolidated financial statements. An entity is subject to FIN 46 and FIN 46-R, and is called a Variable Interest Entity (“VIE”), if it has (i) equity that is insufficient to permit the entity to finance its activities without additional subordinated financial support or (ii) equity investors that cannot make significant decisions about the entity’s operations or that do not absorb the majority of expected losses or receive the majority of expected residual returns of the entity. A VIE is consolidated by its primary beneficiary, which is the party that has a majority of the expected losses or a majority of the expected residual returns of the VIE or both. FIN 46 requires disclosures for companies that have either a primary or significant variable interest in a VIE. All other entities not considered VIEs are evaluated for consolidation under SFAS No. 94, “Consolidation of all Majority-Owned Subsidiaries”. Ambac Assurance adopted FIN 46-R as of December 31, 2003. See Note 7 for a further discussion of the impact of Special Purpose Entities and VIEs on Ambac Assurance’s financial statements.

ACCOUNTING STANDARDS:

In December 2004, the FASB issued SFAS 123-R, “Share-Based Payment”. This Statement is a revision of SFAS 123, “Accounting for Stock-Based Compensation” and supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees”, and its related implementation guidance. SFAS 123-R requires entities to recognize compensation cost for all equity-classified awards after the effective date using the fair-value measurement method. SFAS 123-R is effective for interim or annual periods beginning after June 15, 2005. Ambac Assurance will adopt SFAS 123-R on July 1, 2005 by using a modified prospective approach. The adoption of SFAS 123-R is not expected to have a material impact on Ambac Assurance’s operating results. Ambac Assurance continues to evaluate other aspects of adopting SFAS 123-R.

On September 30, 2004, the FASB voted unanimously to delay the effective date of certain provisions in EITF 03-1, “The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments”. The delay applies to both debt and equity securities and specifically applies to impairments caused by changes in interest rate and credit spreads. In addition, the provisions of EITF 03-1 that have been delayed relate to the requirements that a company declare its intent to hold the security to recovery and designate a recovery period in order to avoid recognizing an other-than-temporary impairment charge through earnings. The FASB will be issuing implementation guidance related to this topic. Once issued, Ambac Assurance will evaluate the impact of adopting EITF 03-1. The disclosures required by EITF 03-1 are included in Note 3 to the consolidated financial statements.

12

AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollar Amounts in Thousands)

In May 2004, the FASB issued FASB Staff Position FAS 106-2, “Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003” (“FSP FAS 106-2”), which superceded FSP FAS 106-1, in response to the December 2003 enactment of the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (“the Act”). The Act introduces a prescription drug benefit for individuals under Medicare (Medicare Part D) as well as a federal subsidy equal to 28% of prescription drug claims for sponsors of retiree health care plans with drug benefits that are at least actuarially equivalent to those to be offered under Medicare Part D. If a plan is determined to be actuarially equivalent to Medicare Part D, FSP FAS 106-2 requires plan sponsors to disclose the effect of the subsidy on the net periodic expense and the accumulated postretirement benefit obligation in their interim and annual financial statements for periods beginning after June 15, 2004. Plan sponsors who initially elected to defer accounting for the effects of the subsidy are allowed the option of retroactive application to the date of enactment or prospective application from the date of adoption. Under FSP FAS 106-1, Ambac Assurance elected to defer the accounting for the effects of the Act. However, Ambac Assurance believes that our plans are eligible for the subsidy and decided to adopt FSP FAS 106-2 in the third quarter of 2004 retroactive to January 1, 2004. The adoption of FSP FAS 106-2 did not have a material effect on Ambac Assurance’s operating results.

RECLASSIFICATIONS:

Certain reclassifications have been made to prior years’ amounts to conform to the current year’s presentation.

13

AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollar Amounts in Thousands)

3 INVESTMENTS

The amortized cost and fair value of investments at December 31, 2004 and 2003 were as follows:

	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Estimated Fair Value
2004:
Fixed income securities:
Municipal obligations	$	5,854,151	$	315,584	$	7,396	$	6,162,339
Corporate obligations		114,563		17,849		—		132,412
Foreign obligations		217,007		21,282		416		237,873
U.S. government obligations		105,727		1,132		101		106,758
U.S. agency obligations		411,000		3,991		2,043		412,948
Mortgage and asset-backed securities		1,380,342		9,515		4,493		1,385,364
Short-term		484,232		—		—		484,232
Other		3,271		425		270		3,426
	$	8,570,293	$	369,778	$	14,719	$	8,925,352
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Estimated Fair Value
2003:
Fixed income securities:
Municipal obligations	$	5,248,331	$	318,163	$	6,391	$	5,560,103
Corporate obligations		436,023		30,711		1,683		465,051
Foreign obligations		156,901		20,942		664		177,179
U.S. government obligations		83,328		819		351		83,796
U.S. agency obligations		215,499		417		718		215,198
Mortgage and asset-backed securities		1,057,879		12,631		4,395		1,066,115
Short-term		213,716		—		—		213,716
Other		3,507		230		426		3,311
	$	7,415,184	$	383,913	$	14,628	$	7,784,469

Foreign obligations consist primarily of government issued securities, which are denominated in either Pounds sterling, Euros or Australian dollars.

14

AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollar Amounts in Thousands)

The amortized cost and estimated fair value of investments at December 31, 2004, by contractual maturity, were as follows:

	Amortized Cost		Estimated Fair Value
2004
Due in one year or less	$	548,511	$	557,769
Due after one year through five years		928,228		958,331
Due after five years through ten years		1,481,605		1,536,985
Due after ten years		4,231,607		4,486,903
		7,189,951		7,539,988
Mortgage and asset-backed securities		1,380,342		1,385,364
	$	8,570,293	$	8,925,352

Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.

At December 31, 2004, the cost of approximately 112 investments in fixed income securities exceeded their fair value by $14,718. There were no individual securities with material unrealized losses as of December 31, 2004 and 2003. The following table shows gross unrealized losses and fair values of Ambac Assurance’s investments, aggregated by investment category and length of time that the individual securities have been in a continuous unrealized loss position, at December 31, 2004 and 2003:

	Less Than 12 Months				12 Months or More				Total
Temporarily Impaired Securities	Fair Value		Unrealized Loss		Fair Value		Unrealized Loss		Fair Value		Unrealized Loss
2004:
Fixed income securities
Municipal obligations	$	409,651	$	4,586	$	124,564	$	2,809	$	534,215	$	7,395
Corporate obligations		—		—		—		—		—		—
Foreign obligations		8,516		13		56,995		403		65,511		416
U.S. government obligations		24,701		101		—		—		24,701		101
U.S. agency obligations		239,116		2,043		—		—		239,116		2,043
Mortgage and asset-backed securities		407,729		2,734		113,667		1,759		521,396		4,493
Other		151		3		852		267		1,003		270
Total temporarily impaired securities	$	1,089,864	$	9,480	$	296,078	$	5,238	$	1,385,942	$	14,718
2003:
Fixed income securities
Municipal obligations	$	433,907	$	5,958	$	6,509	$	433	$	440,416	$	6,391
Corporate obligations		90,940		1,683		—		—		90,940		1,683
Foreign obligations		36,557		664		—		—		36,557		664
U.S. government obligations		50,210		351		—		—		50,210		351
U.S. agency obligations		193,774		718		—		—		193,774		718
Mortgage and asset-backed securities		280,550		4,395		—		—		280,550		4,395
Other		146		7		1,514		419		1,660		426
Total temporarily impaired securities	$	1,086,084	$	13,776	$	8,023	$	852	$	1,094,107	$	14,628

15

AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollar Amounts in Thousands)

Of the $9,480 and $13,776 that have been in a gross unrealized loss position for less than a year, 100% and 99% are rated investment grade for 2004 and 2003, respectively. Of the $5,238 and $852 that have been in a gross unrealized loss position for a year or more, 95% and 96% are rated investment grade for 2004 and 2003. The unrealized loss on these securities reflects the current interest rate environment.

Management has determined that the unrealized losses on Ambac Assurance’s investments in fixed income securities at December 31, 2004 are temporary in nature. Ambac Assurance conducts a review each quarter to identify and evaluate investments that have indications of possible impairment. An investment in a debt security is impaired if its fair value falls below its cost and the decline is considered other-than-temporary. Factors considered when assessing impairment include: (i) securities whose fair values have declined by 20% or more below amortized cost; (ii) securities whose market values have declined by 5% or more below amortized cost for a continuous period of at least six months; (iii) recent downgrades by rating agencies; (iv) the financial condition of the issuer; (v) whether scheduled interest payments are past due; and (vi) whether Ambac Assurance has the ability and intent to hold the security for a sufficient period of time to allow for anticipated recoveries in fair value.

If we believe a decline in the value of a particular investment is temporary, we record the decline as an unrealized loss in Accumulated Other Comprehensive Income in Stockholder’s Equity, net of income tax, on our Consolidated Balance Sheets. If we believe the decline is “other than temporary”, we write down the carrying value of the investment and record a loss on our Consolidated Statements of Operations. Ambac Assurance’s assessment of a decline in value includes management’s current judgment of the factors noted above. If that judgment changes in the future, Ambac Assurance may ultimately record a loss after having originally concluded that the decline in value was temporary. There were no impairment write-downs during 2004, 2003 or 2002.

Securities carried at $6,644 and $6,959 at December 31, 2004 and 2003 respectively, were deposited by Ambac Assurance with governmental authorities or designated custodian banks as required by laws affecting insurance companies.

Net investment income of Ambac Assurance comprised the following:

	2004			2003			2002
Fixed income securities	$	361,864		$	322,098		$	297,740
Short-term investments		2,465			2,321			2,801
Loans		1,638			—			—
Total investment income		365,967			324,419			300,541
Investment expense		(4,881	)		(3,330	)		(3,275	)
Net investment income	$	361,086		$	321,089		$	297,266

Net realized investment gains were $30,004, $40,190 and $40,918 in 2004, 2003 and 2002, respectively. The following table details amounts included in net realized gains:

	2004			2003			2002
Gross realized gains on securities sold	$	40,346		$	36,810		$	45,344
Gross realized losses on securities sold		(15,996	)		(5,148	)		(6,276	)
Foreign exchange gains on investments		5,654			8,528			1,850
Net realized gains	$	30,004		$	40,190		$	40,918

16

AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollar Amounts in Thousands)

4 REINSURANCE

In the ordinary course of business, Ambac Assurance cedes exposures under various reinsurance contracts primarily designed to minimize losses from large risks and to protect capital and surplus. The effect of reinsurance on premiums written and earned was as follows:

	Year Ended December 31,
	2004						2003						2002
	Written			Earned			Written			Earned			Written			Earned
Direct	$	1,011,646		$	783,929		$	1,119,914		$	698,526		$	875,928		$	521,177
Assumed		38,568			38,059			29,258			36,958			32,962			41,486
Ceded		(70,946	)		(99,077	)		(138,146	)		(108,811	)		(113,542	)		(85,071	)
Net premiums	$	979,268		$	722,911		$	1,011,026		$	626,673		$	795,348		$	477,592

The reinsurance of risk does not relieve Ambac Assurance of its original liability to its policyholders. In the event that any of Ambac Assurance’s reinsurers are unable to meet their obligations under reinsurance contracts, Ambac Assurance would nonetheless, be liable to its policyholders in the full amount of its policy.

Ambac Assurance’s reinsurance assets, including prepaid reinsurance and reinsurance recoverables on losses amounted to $314,095 at December 31, 2004. This credit exposure existed at December 31, 2004 with respect to reinsurance recoverables to the extent that any reinsurer may not be able to reimburse Ambac Assurance under the terms of these reinsurance arrangements. At December 31, 2004, approximately 30% of the reinsurance assets were due from unauthorized reinsurers. In order to obtain statutory recognition, all of these amounts were collateralized ($214,525 of collateral at December 31, 2004). The collateral can be drawn on for amounts that remain unpaid beyond specified time periods on an individual reinsurer basis. The remaining 70% of the reinsurance assets were from authorized reinsurers. The terms authorized and unauthorized pertain to regulatory categories, not credit worthiness. Approximately 85% of the balances with respect to authorized reinsurers are from reinsurers rated AA or better, as rated by Standard and Poor’s. This rating is a measure of financial strength.

To minimize exposure to significant losses from reinsurers, Ambac Assurance (i) monitors the financial condition of its reinsurers; (ii) has collateral provisions in certain reinsurance contracts and (iii) has certain termination triggers that can be exercised by Ambac Assurance in the event of a rating downgrade of a reinsurer. For the years ended December 31, 2004, 2003 and 2002, reinsurance recoveries, which reduced loss and loss expenses incurred, amounted to $2,581, $4,041 and $1,334, respectively. Reinsurance recoverables on paid losses and loss expenses as of December 31, 2004 and 2003 were $266 and $495, respectively. Ambac Assurance pledged cash and fixed income securities to foreign insurers of $15,086 and $13,584 at December 31, 2004 and 2003, respectively, related to business assumed from those insurers.

17

AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollar Amounts in Thousands)

5 LOSSES AND LOSS EXPENSE RESERVE

As discussed in Note 2, Ambac Assurance’s liability for losses and loss expenses consists of case basis and active credit reserves. Following is a summary of the activity in the case basis credit and active credit reserve accounts and the components of the liability for loss and loss expense reserves:

	2004			2003			2002
Case basis credit loss and loss expense reserves:
Balance at January 1	$	57,233		$	53,592		$	24,384
Less: reinsurance recoverables		2,535			4,600			1,021
Net balance at January 1		54,698			48,992			23,363
Transfers from active credit reserves:
Current year		40,215			25,361			36,365
Prior years		40,765			14,403			(1,480	)
Total transfers from active credit reserves		80,980			39,764			34,885
Paid (net of recoveries) related to:
Current year		214			9,825			5,740
Prior years		18,709			24,233			3,516
Total paid		18,923			34,058			9,256
Net balance at December 31		116,755			54,698			48,992
Plus reinsurance recoverables		16,499			2,535			4,600
Balance at December 31		133,254			57,233			53,592
Active credit reserve:
Balance at January 1		132,181			118,545			126,730
Provision for losses		69,600			53,400			26,700
Transfers to case reserves		(80,980	)		(39,764	)		(34,885	)
Balance at December 31		120,801			132,181			118,545
Total	$	254,055		$	189,414		$	172,137

During 2004, 2003 and 2002, gross losses paid were $55,321, $45,621, and $11,143, respectively. During 2004, 2003 and 2002, recoveries from reinsurers for paid losses were $2,769, $4,041 and $1,334, respectively. During 2004, 2003 and 2002, other recoveries of losses were $33,628, $7,522 and $553, respectively.

The provision for losses and loss expenses represents the expense recorded to bring the total reserve (active credit and case basis credit) to a level determined by management to be adequate for losses inherent in the non-derivative financial guaranty insurance portfolio as of the reporting date. The provision for losses of $69,600 is the amount recorded as loss and loss expenses in the Consolidated Statement of Operations. Provisions are recognized through the active credit reserve based on the on-going analysis of the portfolio as discussed in Note 2. Upon default of the underlying credit, the reserve is transferred from active credit reserves to case basis credit reserves. Additional provisions for losses upon further credit deterioration of a defaulted exposure are initially recorded in active credit reserve and subsequently transferred to case basis credit reserve. The 2004 provision for losses was primarily impacted by two credits. The first credit is a domestic health care institution, which defaulted in a prior year and continues to experience significant financial stress. Ambac Assurance’s gross exposure to this credit amounts to approximately $73,000 at December 31, 2004. There is no reinsurance for this exposure. At December 31, 2004, $40,000 of case basis reserves were held for this healthcare exposure. During 2004, $25,000 of additional provision for losses was recorded for this transaction based on our

18

AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollar Amounts in Thousands)

analysis of deteriorating financial information. Ambac Assurance is closely surveilling the credit and is in frequent communication with management. Ambac Assurance believes the primary factor causing the loss on this exposure is the competitive local environment for health care delivery and the resulting impact on revenue generation. The second credit is an enhanced equipment trust certificate (“EETC”) securitization. This transaction is secured by seven commercial aircraft, including the lease income generated by leases of the aircraft to a commercial airline. During 2004 the airline leasing the aircraft filed for bankruptcy and defaulted on its lease obligations. Ambac Assurance insured the most senior debt layer of the transaction and has gross exposure to this transaction of approximately $174,000. The exposure net of reinsurance is approximately $127,000. At December 31, 2004, approximately $55,000 of gross case reserves were held for this EETC exposure ($40,000, net of reinsurance). Provision for losses of $40,000 was recorded during 2004 to reflect the deterioration of this exposure. A reduction of any of the outstanding exposure is entirely dependent upon the value of the aircraft collateral underlying the transaction. Ambac Assurance is entitled to direct that the aircraft be sold outright or leased and the related proceeds would be used to reduce the exposure outstanding. Aircraft valuations have declined sharply over recent years. Management believes the primary factor that has adversely impacted collateral values is the severely distressed financial condition of the airline industry. The airline industry has been adversely impacted by several factors including the September 11 terror attacks on the United States and the related adverse impact it had on passenger demand. Other important factors adversely impacting the airline industry include high fuel costs and intense price competition.

6 INCOME TAXES

The total effect of income taxes on income and stockholder’s equity for the years ended December 31, 2004 and 2003 was as follows:

	2004			2003			2002
Total income taxes charged to income	$	273,845		$	244,942		$	188,969
Income taxes (credited) charged to stockholder’s equity:
Unrealized (losses) gains on bonds		(4,907	)		4,442			80,177
Exercise of stock options		(16,403	)		(11,894	)		(505	)
Total credited to stockholder’s equity		(21,310	)		(7,452	)		79,672
Total effect of income taxes	$	252,535		$	237,490		$	268,641

19

AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollar Amounts in Thousands)

The tax provisions in the accompanying Consolidated Statements of Operations reflect effective tax rates differing from prevailing Federal corporate income tax rates. The following is a reconciliation of these differences:

	2004			%		2003			%		2002			%
Computed expected tax at statutory rate	$	364,417		35.0	%	$	320,634		35.0	%	$	255,282		35.0	%
Reductions in expected tax resulting from:
Tax-exempt income		(79,564	)	(7.6	)		(73,652	)	(8.0	)		(63,065	)	(8.6	)
Release of tax reserves		(8,250	)	(0.8	)		—		0.0			—		0.0
Other, net		(2,758	)	(0.3	)		(2,040	)	(0.3	)		(3,248	)	(0.5	)
Income tax expense	$	273,845		26.3	%	$	244,942		26.7	%	$	188,969		25.9	%

The release of tax reserves relates to the expiration of the statute of limitations of an earlier tax year.

The tax effects of temporary differences that give rise to significant portions of the deferred tax liabilities and deferred tax assets at December 31, 2004 and 2003 are presented below:

	2004		2003
Deferred tax liabilities:
Contingency reserve	$	306,957	$	266,957
Unrealized gains on bonds		124,245		129,151
Deferred acquisition costs		71,141		62,835
Unearned premiums and credit fees		85,654		60,217
Other		7,110		7,387
Total deferred tax liabilities		595,107		526,547
Deferred tax assets:
Tax and loss bonds		271,371		231,371
Loss reserves		43,834		46,814
Compensation		18,521		11,950
Other		4,997		3,622
Sub-total deferred tax assets		338,723		293,757
Valuation allowance		—		—
Total deferred tax assets		338,723		293,757
Net deferred tax liabilities	$	256,384	$	232,790

Ambac Assurance believes that no valuation allowance is necessary in connection with the deferred tax assets. It is more likely than not that the results of future operations will generate sufficient taxable income to realize the deferred tax assets.

7 SPECIAL PURPOSE ENTITIES AND VARIABLE INTEREST ENTITIES

Ambac Financial Group has involvement with special purpose entities, including VIEs in the following ways. First, Ambac Assurance is a provider of financial guarantee insurance for various securitized asset-backed debt obligations. Second, Ambac Financial Group has sponsored two special purpose entities that issue medium-term notes (“MTNs”) to fund the purchase of certain financial assets. As discussed in detail below, these Ambac Financial Group sponsored special purpose entities are

20

AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollar Amounts in Thousands)

considered Qualifying Special Purpose Entities (“QSPEs”). Lastly, Ambac Assurance has a beneficial interest in a variable interest entity that purchases fixed rate municipal bonds with proceeds from the issuance of floating rate short term beneficial interests as discussed in detail below.

Financial Guarantees:

Ambac Assurance provides financial guarantee insurance to securitized asset-backed debt obligations of special purpose entities, including VIEs. Ambac Assurance’s primary variable interest exists through this financial guarantee insurance contract. The transaction structure provides certain financial protection to Ambac Assurance. This financial protection can take several forms, however, the most common are over-collateralization, first loss retention and excess spread. In the case of over-collateralization (i.e., the principal amount of the securitized assets exceeds the principal amount of the structured finance obligations guaranteed by Ambac Assurance), the structure allows the transaction to experience defaults among the securitized assets before a default is experienced on the structured finance obligations that have been guaranteed by Ambac Assurance. In the case of first loss retention, the financial guarantee insurance policy only covers a senior layer of losses on debt issued by special purpose entities, including VIEs. The first loss with respect to the assets is either retained by the seller or sold off in the form of equity or mezzanine debt to other investors. In the case of excess spread, the financial assets contributed to special purpose entities, including VIEs, generate interest cash flows that are in excess of the interest payments on the related debt. All or a portion of this excess spread accumulates and is available to absorb losses in the transaction or is applied to create over-collateralization.

As of December 31, 2004, Ambac Assurance is the primary beneficiary and therefore consolidated VIEs under three transactions, as a result of providing financial guarantees to these entities. Ambac Assurance consolidated these entities since the structural financial protections are outside the VIEs. These structural protections, had they existed inside the VIEs, would have absorbed a majority of the VIEs’ expected losses and consequently Ambac Assurance would not have consolidated these entities. All consolidated VIEs are bankruptcy remote special purpose financing entities created to facilitate the sale of notes guaranteed by Ambac Assurance. Ambac Assurance is not primarily liable for the debt obligations of these entities. Ambac Assurance would only be required to make payments on these debt obligations in the event that the issuer defaults on any principal or interest due. Additionally, Ambac Assurance’s creditors do not have rights with regard to the assets of these VIEs.

Proceeds from the note issuance of the first VIE transaction, which closed in 2002, were used to purchase senior mortgage-backed floating rate notes of a Korean mortgage-backed securities issuer. Protections afforded Ambac Assurance in this transaction were in the form of a reserve fund and the issuance of subordinated debt. Ambac Assurance will pay claims under its financial guarantee only in the event that losses on the mortgage assets of the Korean issuer reduce the reserve fund to zero and exceed the principal amount of the subordinated notes. Total long-term debt outstanding under this note issuance was $119,504 with a maturity date of December 3, 2022 and a variable rate of interest which was 2.30% and 1.64% at December 31, 2004 and 2003, respectively.

Proceeds from the note issuances of the other transactions, both of which closed in 2004, were used to purchase notes issued by special purpose reinsurance companies in connection with their reinsurance of defined blocks of life insurance contracts. Protections afforded Ambac Assurance were in the form of capital contributed to the reinsurance companies and the issuance of subordinated debt by the VIEs. Ambac Assurance will pay claims under its financial guarantees in these transactions if cash flows generated under the reinsurance agreements and the proceeds from the contributed capital and subordinated debt are

21

AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollar Amounts in Thousands)

insufficient to repay the noteholders. Total debt outstanding under these note issuances were $954,864 at December 31, 2004, with maturity dates ranging from April 15, 2016 to February 4, 2025. At December 31, 2004 the interest rate on these notes ranged from 2.38% to 5.11%. Under one of these transactions, Ambac Assurance is subject to potential consolidation of an additional $350,000 of assets and liabilities in connection with future utilization of the VIE by the reinsurer.

The following table provides supplemental information about the combined assets and liabilities associated with the VIEs discussed above. The assets and liabilities of these VIEs are consolidated into the respective Balance Sheet captions.

	At December 31, 2004		At December 31, 2003
Assets:
Cash	$	690	$	90
Loans		727,294		—
Investment in fixed income securities		346,111		189,151
Investment income due and accrued		2,315		241
Total	$	1,076,410	$	189,482
Liabilities:
Long-term debt	$	1,074,368	$	189,151
Other liabilities		2,042		331
Total	$	1,076,410	$	189,482

Disclosures made in Note 3, “Investments,” include investments in fixed income securities for all three VIE transactions. At December 31, 2004, the loan outstanding had a fixed interest rate of 4.906% and an expected final maturity date of April 2011.

Qualified Special Purpose Entities:

Ambac Financial Group 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. These entities meet the characteristics of QSPEs in accordance with Statement of Financial Accounting Standards 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities” (“SFAS 140”). QSPEs are not subject to the requirements of FIN 46-R and accordingly are not consolidated in Ambac Financial Group’s or Ambac Assurance’s financial statements. The QSPEs are legal entities that are demonstrably distinct from Ambac Financial Group. Ambac Financial Group, its affiliates or its agents cannot unilaterally dissolve the QSPEs. The QSPEs permitted activities are limited to those outlined below.

As of December 31, 2004, there have been 14 individual transactions (one in 2004) processed through the QSPEs of which 10 are outstanding. In each case, Ambac Financial Group sells fixed income debt obligations to the QSPEs. These transactions are true sales based upon the bankruptcy remote nature of the QSPE and the absence of any agreement or obligation for Ambac Financial Group to repurchase or redeem assets of the QSPE. The purchase by the QSPE is financed through the issuance of MTNs, which are collateralized by the purchased assets. The cash flows of the MTNs approximately match the cash flows of the assets purchased. Derivative contracts (interest rate and currency swaps) may be used for hedging purposes only. Derivative hedges are established at the time MTNs are issued to purchase financial assets. The activities of the QSPEs are contractually limited to purchasing assets from Ambac, issuing MTNs to fund such purchase, 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

22

AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollar Amounts in Thousands)

December 31, 2004, Ambac Assurance had financial guarantee insurance policies issued for all assets and MTNs owned and outstanding by the QSPEs.

Ambac Assurance’s exposures under these financial guarantee insurance policies as of December 31, 2004 and December 31, 2003 are included in the disclosure in Note 11 “Guarantees in Force”. Pursuant to the terms of Ambac Assurance’s insurance policy, insurance premiums are paid to Ambac Assurance by the QSPEs and are earned in a manner consistent with other insurance policies, over the risk period. Any losses incurred would be included in Ambac Assurance’s Consolidated Statements of Operations. Under the terms of an Administrative Agency Agreement, Ambac provides certain administrative duties, primarily collecting amounts due on the obligations and making interest payments on the MTNs.

Assets sold to the QSPEs during 2004, 2003 and 2002 were $195,000, $250,000 and $350,000, respectively. No gains or losses were recognized on these sales. As of December 31, 2004, the estimated fair value of financial assets, MTN liabilities and derivative hedge liabilities were $2,011,868, $1,820,918 and $171,378, respectively. When market quotes are not available, estimated fair value is determined utilizing valuation models. These models include estimates, made by Ambac Financial Group management, which utilize current market information. The valuation results from these models could differ materially from amounts that would actually be realized in the market. Ambac Assurance received gross premiums for issuing financial guarantee policies on the assets, MTNs and derivative contracts of $6,042, $5,278 and $19,255 for the years ended December 31, 2004, 2003 and 2002, respectively. Ambac Financial Group also received fees for providing other services amounting to $393, $461 and $80 for 2004, 2003 and 2002, respectively.

VIE Beneficial Interest:

Ambac Assurance owns a beneficial interest in a special purpose entity that meets the definition of a VIE. This entity has issued floating rate beneficial interests to investors and invested the proceeds in fixed income municipal investment securities. These beneficial interests are directly secured by the related municipal investment securities. Ambac Assurance is the primary beneficiary of this entity as a result of its beneficial interest. The fixed income municipal investment securities, which are reported as Investments in fixed income securities, at fair value on the Consolidated Balance Sheets, were $257,300 and $254,756 as of December 31, 2004 and 2003. The beneficial interests issued to third parties, are reported as Obligations under payment agreements on the Consolidated Balance Sheets, were $249,140 and $249,810 as of December 31, 2004 and 2003. As of December 31, 2004 and 2003, the interest rates on these beneficial interests ranged from 0.87% to 2.03% and from 0.68% to 1.42%, respectively.

8 EMPLOYEE BENEFITS

Pensions:

Ambac Financial Group has a defined benefit pension plan covering substantially all employees of Ambac Assurance. The benefits are based on years of service and the employee’s highest salary during five consecutive years of employment within the last ten years of employment. Ambac Financial Group’s funding policy is to contribute annually the maximum amount that can be deducted for Federal income tax purposes. Contributions for 2005 are estimated to be approximately $1,000. Contributions are intended to provide not only for benefits attributed to service-to-date, but also for those expected to be earned in the future.

23

AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollar Amounts in Thousands)

The table below sets forth a reconciliation of the beginning and ending projected benefit obligation, beginning and ending balances of the fair value of plan assets, and the funded status of the plan as of December 31, 2004 and 2003.

	2004			2003
Accumulated Benefit Obligation at End of Year:	$	19,304		$	17,255
Change in Projected Benefit Obligation:
Projected benefit obligation at beginning of year	$	23,037		$	18,030
Service cost		1,697			1,653
Interest cost		1,284			1,151
Actuarial (gain) loss		(266	)		2,447
Benefits paid		(323	)		(244	)
Projected benefit obligation at end of year	$	25,429		$	23,037
Change in Plan Assets:
Fair value of plan assets at beginning of year	$	21,998		$	12,521
Actual return on plan assets		2,843			4,021
Ambac Financial Group contributions		2,300			5,700
Benefits paid		(323	)		(244	)
Fair value of plan assets at end of year	$	26,818		$	21,998
Funded status	$	1,389		$	(1,039	)
Unrecognized loss		4,342			5,566
Unrecognized prior service cost		(70	)		(118	)
Prepaid pension asset	$	5,661		$	4,409

Ambac Financial Group employs a total return investment approach whereby a mix of equity and bond mutual funds are used to maximize the long-term return of plan assets for a prudent level of risk. Risk tolerance is established through careful consideration of plan liabilities, plan funded status, and corporate financial condition. The plan strives to have diversification so that adverse or unexpected results from one security class will not have an unduly detrimental impact on the entire portfolio. The investment policy establishes a target allocation for each class which is rebalanced as deemed necessary. Target asset allocations are 40% large capitalization U.S. equity index mutual funds, 30% U.S. bond index mutual funds, 20% international equity mutual funds and 10% small capitalization U.S. equity mutual funds.

The fair value of total plan assets at December 31, 2004 and 2003 by asset category were as follows:

	2004		2003
Equity mutual funds	74	%	72	%
Bond mutual funds	26	%	28	%
	100	%	100	%

24

AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollar Amounts in Thousands)

Ambac Financial Group’s net pension costs for the years ended December 31, 2004, 2003 and 2002 included the following components:

	2004			2003			2002
Service cost	$	1,697		$	1,653		$	1,397
Interest cost		1,283			1,151			992
Expected return on plan assets		(2,027	)		(1,664	)		(1,289	)
Amortization of prior service cost		(144	)		(131	)		(131	)
Recognized net loss		102			37			—
Other		136			—			—
Net periodic pension cost	$	1,047		$	1,046		$	969

The following assumptions were used to determine the projected benefit obligation at the measurement date (December 31) and the net periodic pension cost for the year:

	2004		2003
Projected Benefit Obligation:
Discount rate	5.75	%	6.00	%
Rate of compensation increase	4.50	%	4.50	%
	2004		2003		2002
Net Periodic Pension Cost:
Discount rate	6.00	%	6.50	%	7.00	%
Expected long-term return on plan assets	8.75	%	8.75	%	8.75	%
Rate of compensation increase	4.50	%	4.50	%	4.50	%

The return on plan assets reflects the weighted-average of the expected long-term rates of return for the security classes of investments. Consideration is given for historical returns and current economic conditions.

Pension expense is allocated to each of Ambac Financial Group’s subsidiaries based on percentage of payroll. Pension expense recorded by Ambac Assurance amounted to $864, $781 and $812 in 2004, 2003 and 2002, respectively.

Postretirement Health Care and Other Benefits:

Ambac Financial Group provides certain medical and life insurance benefits for retired employees and eligible dependents. All plans are contributory. None of the plans are currently funded. Expenses are allocated to each of Ambac Financial Group’s subsidiaries based on a percentage of payroll. Ambac Assurance’s postretirement benefits expense was $207, $127 and $73 in 2004, 2003 and 2002, respectively. Ambac Financial Group’s unfunded accumulated postretirement benefit obligation was $3,264, and the related accrued postretirement liability was $3,537 as of December 31, 2004.

The assumed health care cost trend rates range from 10.5% in 2005, decreasing ratably to 6% in 2010. Increasing the assumed health care cost trend rate by one percentage point in each future year would increase Ambac Financial Group’s accumulated postretirement benefit obligation at December 31, 2004, by $797 and Ambac Financial Group’s 2004 benefit expense by $118. Decreasing the assumed health care cost trend rate by one percentage point in each future year would decrease Ambac Financial Group’s accumulated postretirement benefit obligation at December 31, 2004 by $517 and Ambac

25

AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollar Amounts in Thousands)

Financial Group’s 2004 benefit expense by $94. The discount rate used to measure the accumulated postretirement benefit obligation was 5.75% and 6.00 % for 2004 and 2003, respectively.

The following table sets forth benefits projected to be paid from Ambac Financial Group’s defined benefit pension and postretirement plans and reflects expected future service where appropriate:

	Amount
2005	$	598
2006		696
2007		763
2008		849
2009		970
All later years		7,319
	$	11,195

9 Incentive Plans

The Ambac 1997 Equity Plan (the “Equity Plan”) provides for the granting of stock options, stock appreciation rights, restricted stock units (“RSUs”), performance units and other awards that are valued or determined by reference to the Ambac Financial Group’s Common Stock. Ambac also maintains the Ambac 1997 Non-Employee Directors Equity Plan, which provides awards of stock options and restricted stock units to non-employee members of the Ambac’s Board of Directors.

Stock Options:

Stock options awarded to employees are exercisable and expire as specified at the time of grant. Such options do not have a per share exercise price less than the fair market value of a share of Ambac Financial Group Common Stock on the date of grant or have a term in excess of ten years from the date of the grant. All employee stock option agreements provide that vesting is accelerated in certain circumstances, such as upon retirement or death. Stock option expense is allocated to each of Ambac Financial Group’s subsidiaries based on the actual number of options granted to each subsidiary’s employees. Total stock option expense amounted to $11,511, $8,430 and $0 in 2004, 2003 and 2002, respectively.

Annual Incentive Program:

Ambac Financial Group has an annual incentive program (the “Program”) that makes available to all eligible employees awards that are based upon the performance of Ambac, the performance of the employee’s department and the performance of the employee. The Program awards consist of cash and RSUs for all employees and, in lieu of a predetermined percentage of cash, RSUs that may be granted to officers at the level of Managing Director and above. RSUs granted in lieu of the first twenty-five percent of the cash award are granted at a twenty-five percent discount to the average of the high and low of Ambac common stock on the date of grant. An eligible employee can elect to defer more than twenty-five percent of their cash award in the form of RSUs, however, the aforementioned discount does not apply. RSUs granted in lieu of the cash award vest equally over three years. The RSUs representing the twenty-five percent discount vest on the fourth anniversary of the date of grant. Prior to vesting, the RSUs cannot be sold or transferred by the participant and are subject to cancellation if the participant’s employment is terminated. All RSU agreements provide that vesting is accelerated in certain

26

AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollar Amounts in Thousands)

circumstances, such as retirement or death. The cost of the cash component of the program for the years ended December 31, 2004, 2003 and 2002 amounted to $34,516, $30,748 and $27,724, respectively. Ambac Assurance’s cost of the RSU awards for the years ended December 31, 2004, 2003 and 2002 were $10,789, $6,167 and $2,465, respectively.

Savings Incentive Plan:

Substantially all employees of Ambac Financial Group are covered by a defined contribution plan (the “Savings Incentive Plan”), for which contributions are determined as 6% of each eligible employee’s eligible base salary, plus a matching company contribution of 50% on contributions up to 6% of base salary made by eligible employees to the Savings Incentive Plan. The total cost of the Savings Incentive Plan to Ambac Assurance was $3,247, $2,799 and $2,019 in 2004, 2003 and 2002, respectively.

10 COMMITMENTS AND CONTINGENCIES

Ambac Assurance is responsible for leases on the rental of office space. The lease agreements, which expire periodically through September 2019, contain provisions for scheduled periodic rent increases and are accounted for as operating leases. An estimate of future net minimum lease payments in each of the next five years ending December 31, and the periods thereafter, is as follows:

	Amount
2005	$	7,848
2006		7,864
2007		7,654
2008		7,896
2009		8,257
All later years		84,060
	$	123,579

Rent expense for the aforementioned leases amounted to $8,507, $7,434 and $6,377 for the years ended December 31, 2004, 2003 and 2002, respectively.

Ambac Assurance provided a $360,000 liquidity facility to a reinsurance company which acts as reinsurer with respect to a portfolio of life insurance policies. The liquidity facility provides temporary funding in the event that the reinsurance company’s capital is insufficient to make payments under the reinsurance agreement. The reinsurance company is required to repay all amounts drawn under the liquidity facility. No amounts have been drawn under this facility at December 31, 2004.

27

AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollar Amounts in Thousands)

11 GUARANTEES IN FORCE

The par amount of financial guarantees outstanding, for non-affiliates, were $502,657,000 and $475,422,000 at December 31, 2004 and 2003, respectively. The par amount of financial guarantees outstanding, for non-affiliates, net of reinsurance, were $459,432,000 and $425,854,000 at December 31, 2004 and 2003, respectively. As of December 31, 2004 and 2003, the guarantee portfolio was diversified by type of guaranteed bond as shown in the following table:

	Net Par Amount Outstanding (1)
(Dollars in Millions)	2004		2003
Public Finance:
Lease and tax-backed revenue	$	76,012	$	66,331
General obligation		49,394		44,350
Utility revenue		36,321		33,598
Health care revenue		23,977		22,120
Transportation revenue		21,188		18,244
Higher education		18,056		15,778
Housing revenue		9,163		9,014
Other		5,588		5,879
Total Public Finance		239,699		215,314
Structured Finance:
Mortgage-backed and home equity		53,148		50,819
Asset-backed and conduits (2)		28,858		27,126
Investor-owned utilities		15,449		14,480
Student loans		14,646		12,807
Pooled debt obligations		13,382		11,492
Other		6,971		7,400
Total Structured Finance		132,454		124,124
International Finance:
Pooled debt obligations		35,911		44,723
Mortgage-backed and home equity		19,644		17,273
Asset-backed and conduits		15,692		12,503
Investor-owned and public utilities		5,965		4,677
Transportation revenue		4,938		3,698
Sovereign/sub-sovereign		3,224		2,353
Other		1,905		1,189
Total International Finance		87,279		86,416
	$	459,432	$	425,854

⁽¹⁾ Included in the above exposures are structured credit derivatives. Total structured credit derivative net par outstanding amounted to $43,478 and $48,825 at December 31, 2004 and 2003, respectively.

⁽²⁾ Included within Asset-backed and conduits are exposures to Enhanced Equipment Trust Certificates of $1,827 and $1,667 at December 31, 2004 and 2003, respectively.

As of December 31, 2004 and 2003, the International Finance guarantee portfolio is shown in the following table by location of risk:

	Net Par Amount Outstanding
(Dollars in Millions)	2004		2003
United Kingdom	$	26,325	$	17,990
Germany		7,842		11,617
Japan		6,063		6,058
Australia		4,569		3,620
Italy		1,641		1,633
Internationally diversified		32,685		38,243
Other international		8,154		7,255
Total International Finance	$	87,279	$	86,416

Internationally diversified obligations represent pools of geographically diversified exposures which includes components of domestic exposure.

28

AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollar Amounts in Thousands)

Direct financial guarantees in force (principal and interest) was $757,037,000 and $707,131,000 at December 31, 2004 and 2003, respectively. Net financial guarantees in force (after giving effect to reinsurance) was $685,234,000 and $625,564,000 as of December 31, 2004 and 2003, respectively.

In the United States, California and New York were the states with the highest aggregate net par amounts in force, accounting for 10.0% and 6.3% of the total at December 31, 2004. No other state accounted for more than five percent. The highest single insured risk represented less than 1% of aggregate net par amount insured.

12 FAIR VALUES OF FINANCIAL INSTRUMENTS

The following fair value amounts were determined by using independent market information when available, and valuation models when market quotes were not available. In cases where specific market quotes are unavailable, interpreting market data and estimating fair values require considerable judgment by management. Accordingly, the estimates presented are not necessarily indicative of the amount Ambac Assurance could realize in a current market exchange. The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value:

Investments: The fair values of fixed income investments are based primarily on quoted market prices received from a nationally recognized pricing service or dealer quotes. When quotes are not available, fair values are estimated based upon internal valuation models.

Short-term investments and cash: The fair values of short-term investments and cash are assumed to approximate amortized cost.

Other investments: The fair value of other investments, primarily mutual funds, are based on quoted market prices received from a nationally recognized pricing service.

Securities purchased under agreements to resell: The fair value of securities purchased under agreements to resell is assumed to approximate carrying value.

Investment income due and accrued: The fair value of investment income due and accrued is assumed to approximate carrying value.

Loans: The fair value of loans are assumed to approximate carrying value.

Derivative contracts held for trading purposes: The fair values of interest rate swaps, currency swaps, total return swaps and structured credit derivative transactions, as discussed in Note 2, are determined by market quotes or valuation models when market quotes are not available.

Obligations under payment agreements: The fair value of payment agreements is assumed to approximate carrying value.

Notes payable to affiliate: The fair values of the notes payable is assumed to equal carrying value.

29

AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollar Amounts in Thousands)

Long-term debt: The fair value of long-term debt issued by consolidated variable interest entities are assumed to approximate carrying value.

Liability for net financial guarantees written: The fair value of the liability for those financial guarantees written is based on the estimated cost to reinsure those exposures at current market rates, which amount consists of the current unearned premium reserve, less an estimated ceding commission thereon.

Other financial guarantee insurance policies have been written on an installment basis, where the future premiums to be received by Ambac Assurance are determined based on the outstanding exposure at the time the premiums are due. The fair value of Ambac Assurance’s liability under its installment premium policies is measured using the present value of estimated future installment premiums, less an estimated ceding commission. The estimate of the amounts and timing of the future installment premiums is based on contractual premium rates, debt service schedules and expected run-off scenarios. This measure is used as an estimate of the cost to reinsure Ambac Assurance’s liability under these policies.

30

AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollar Amounts in Thousands)

The carrying amount and estimated fair value of financial instruments are presented below:

	As of December 31,
	2004				2003
(Dollars in Millions)	Carrying Amount		Estimated Fair Value		Carrying Amount		Estimated Fair Value
Financial assets:
Fixed income securities	$	8,438	$	8,438	$	7,567	$	7,567
Short-term investments		484		484		214		214
Other investments		3		3		3		3
Cash		18		18		18		18
Securities purchased under agreements to resell		52		52		139		139
Investment income due and accrued		105		105		99		99
Derivative assets:
Trading purposes		1,298		1,298		1,146		1,146
Loans		731		731		—		—
Financial liabilities:
Obligations under payments agreements		249		249		250		250
Note payable to affiliate		—		—		84		84
Derivative liabilities:
Trading purposes		1,207		1,207		1,088		1,088
Long-term debt		1,074		1,074		189		189
Liability for financial guarantees written:
Gross		2,783		2,087		2,553		1,787
Net of reinsurance		2,485		1,864		2,228		1,560
Gross installment premiums		—		1,769		—		1,311
Net installment premiums		—		1,545		—		1,089

13 INSURANCE REGULATORY

Ambac Assurance is subject to insurance regulatory requirements of the States of Wisconsin and New York, and the other jurisdictions in which it is licensed to conduct business.

Ambac Assurance’s ability to pay dividends is generally restricted by law and subject to approval by the Office of the Commissioner of Insurance of the State of Wisconsin. Wisconsin insurance law restricts the payment of dividends in any 12-month period without regulatory approval to the lesser of (a) 10% of policyholders’ surplus as of the preceding December 31 and (b) the greater of (i) statutory net income for the calendar year preceding the date of dividend, minus realized capital gains for that calendar year and (ii) the aggregate of statutory net income for three calendar years preceding the date of the

31

AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollar Amounts in Thousands)

dividend, minus realized capital gains for those calendar years and minus dividends paid or credited within the first two of the three preceding calendar years. Based upon these restrictions, at December 31, 2004, the maximum amount that will be available during 2005 for payment of dividends by Ambac Assurance is approximately $320,000. Ambac Assurance paid cash dividends of $103,000, $89,600 and $78,000 on its common stock in 2004, 2003 and 2002, respectively.

The New York Financial Guarantee Insurance Law establishes single risk limits applicable to obligations insured by Ambac Assurance. Such limits are specific to the type of insured obligation (for example, municipal or asset-backed). The limits compare the insured net par outstanding and average annual debt service, 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 of December 31, 2004 and 2003, Ambac Assurance and its subsidiaries were in compliance with these regulatory requirements.

Ambac Assurance’s statutory financial statements are prepared on the basis of accounting practices prescribed or permitted by the Wisconsin Insurance Department. Effective January 1, 2001, Wisconsin adopted the National Association of Insurance Commissioners’ statutory accounting practices (“NAIC SAP”) as a component of its prescribed accounting practices. The adoption of the NAIC SAP did not have a material effect on Ambac Assurance’s statutory capital. Wisconsin’s accounting practice for changes to the contingency reserve differ from those practices of NAIC SAP. Under NAIC SAP, contributions to and releases from the contingency reserve are recorded via a direct charge or credit to surplus. Under the Wisconsin Administrative Code, contributions to and release from the contingency reserve are to be recorded through underwriting income. Ambac Assurance received permission of the Wisconsin Insurance Commissioner to record contributions to and releases from the contingency reserve in accordance with NAIC SAP. Statutory surplus is the same using each of these accounting practices. Statutory net income is higher than if Ambac Assurance had reported the net contributions in accordance with the Wisconsin Administrative Code by $235,881, $234,219 and $169,015 for 2004, 2003 and 2002, respectively.

Statutory capital and surplus was $3,198,699 and $2,739,675 at December 2004 and 2003, respectively. Qualified statutory capital was $5,224,491 and $4,525,991 at December 31, 2004 and 2003, respectively. Statutory capital and surplus differs from stockholder’s equity determined under GAAP principally due to statutory accounting rules that treat loss reserves, premiums earned, policy acquisition costs, and deferred income taxes differently. Statutory net income for Ambac Assurance was $693,176, $584,160 and $486,246 for 2004, 2003 and 2002, respectively.

14 LONG-TERM DEBT AND LINES OF CREDIT

The long-term debt represents notes issued by consolidated variable interest entities. Ambac Assurance is the primary beneficiary of these VIEs as a result of providing financial guarantees on the variable interest entity notes. Consequently, Ambac Assurance has consolidated the notes issued by the VIEs, and all other assets and liabilities of these VIEs. Ambac Assurance is not primarily liable for the debt obligations of these entities. Ambac Assurance would only be required to make payments on these debt obligations in the event that the issuer defaults on any principal or interest due. Ambac Assurance’s creditors do not have rights with regard to the assets of these VIEs. Please refer to Note 7 for a detailed description of the variable interest entity notes.

32

AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollar Amounts in Thousands)

At December 31, 2003, Ambac Private Holdings had an unsecured note payable to an affiliate, Ambac Investments, Inc. with a carrying value of $12,500 and a maturity date of October 30, 2006. This note pays interest quarterly at 0.2% below three month LIBOR, currently at 0.97%. The outstanding balance was repaid in 2004.

Ambac Financial Group and Ambac Assurance have a revolving credit facility with six major international banks for $300,000, which expires in July 2005 and provides a two-year term loan provision. The facility is available for general corporate purposes, including the payment of claims. As of December 31, 2004, no amounts were outstanding under this credit facility. This facility’s financial covenants require that Ambac Financial Group: (i) maintain as of the end of each fiscal quarter a debt to capital ratio of not more than 30% and (ii) maintain at all times total stockholders’ equity equal to or greater than $2.0 billion. At December 31, 2004, Ambac Financial Group met all of these requirements. Prior to July 2004, Ambac Financial Group and Ambac Assurance had a revolving credit facility with eight major international banks for $300,000. During 2004 and 2003, Ambac Financial Group paid $481 and $457, respectively, for these credit facilities.

Ambac Assurance has a series of perpetual put options on its own preferred stock. The counterparty to these put options are trusts established by a major investment bank. The trusts were created as a vehicle for providing capital support to Ambac Assurance by allowing Ambac Assurance to obtain immediate access to new capital at its sole discretion at any time through the exercise of the put option. If the put option were exercised, Ambac Assurance would receive up to $800,000 in return for the issuance of its own perpetual preferred stock, the proceeds of which may be used for any purpose including the payment of claims. The preferred stock would give investors the rights of an equity investor in Ambac Assurance. Such rights are subordinate to insurance claims, as well as to the general unsecured creditors of Ambac Assurance. Dividend payments on the preferred stock are cumulative only if Ambac Assurance pays dividends on its common stock. Each trust is restricted to holding high quality short-term commercial paper investments to ensure that it can meet its obligations under the put option. To fund these investments, each trust has issued its own auction market perpetual securities. Ambac Assurance pays a put option fee. Each trust is rated AA/Aa2 by Standard & Poor’s and Moody’s respectively. During 2004 and 2003 Ambac Assurance paid put option fees of $4,698 and $4,671, respectively, which is recorded in adjusted paid-in capital on the consolidated financial statements.

15 RELATED PARTY TRANSACTIONS

During 2004 and 2003, Ambac Assurance guaranteed the timely payment of principal and interest on obligations under investment agreements and investment repurchase agreements issued by its affiliates. As of December 31, 2004 and 2003, the principal amount of investment agreements and investment repurchase agreements insured was $6,085,153 and $6,052,211, respectively, including accrued interest. The guarantees are collateralized by investment securities, accrued interest receivable, securities purchased under agreements to resell, cash and cash equivalents and other financial assets, which as of December 31, 2004 and 2003, had a fair value of $6,191,279 and $6,109,248, respectively, in the aggregate. Certain investment agreements may be terminated at fair value. During 2004 and 2003, Ambac Assurance recorded gross premiums written of $2,403 and $5,468, and net premiums earned of $6,253 and $6,356, respectively, related to these agreements.

During 2004 and 2003, several interest rate swap transactions were executed between Ambac Financial Services and its affiliates (other than Ambac Assurance). As of December 31, 2004 and 2003, these contracts had an outstanding notional amount of approximately $1,727,000 and $1,296,000,

33

AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollar Amounts in Thousands)

respectively. As of December 31, 2004 and 2003, Ambac Financial Services recorded liabilities of $141,536 and $141,948, respectively, related to these transactions.

In 2004 and 2003, Ambac Assurance received capital contributions totaling $62,606 and $210,384, respectively, from Ambac Financial Group, Inc.

16 SEGMENT INFORMATION

Ambac Assurance has two reportable segments, as follows: (1) financial guarantee, which provides financial guarantees (including structured credit derivatives) for public finance and structured finance obligations and (2) financial services, which provides payment agreements, interest rate, currency and total return swaps.

Ambac Assurance’s reportable segments are strategic business units that offer different products and services. They are managed separately because each business requires different marketing strategies, personnel skill sets and technology.

The accounting policies of the segments are described in Note 2 “Significant Accounting Policies”. Pursuant to insurance and indemnity agreements between Ambac Financial Services and Ambac Assurance, Ambac Financial Services’ payment obligations under its swap agreements are guaranteed by Ambac Assurance. Additionally, the payment obligations of Ambac Financial Services’ counterparties, under their swap agreements with Ambac Financial Services, are guaranteed by Ambac Assurance pursuant to insurance and indemnity agreements. Intersegment revenues include the premiums earned under those agreements. Such premiums are determined as if they were premiums to third parties, that is, at current market prices. In 2004 and 2003, Financial Guarantee intersegment revenues include dividends of $17,658 and $9,767, respectively, from the Financial Services segment.

34

AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollar Amounts in Thousands)

The following table is a summary of the financial information by reportable segment as of and for the years ended December 31, 2004, 2003 and 2002:

	Financial Guarantee		Financial Services			Intersegment Eliminations			Total Consolidated
2004:
Revenues:
External customers	$	1,185,662	$	47,627		$	—		$	1,233,289
Intersegment		20,018		—			(20,018	)		—
Total revenues	$	1,205,680	$	47,627		$	(20,018	)	$	1,233,289
Income before income taxes:
External customers	$	1,004,204	$	36,986		$	—		$	1,041,190
Intersegment		21,804		(4,146	)		(17,658	)		—
Total income before income taxes	$	1,026,008	$	32,840		$	(17,658	)	$	1,041,190
Identifiable assets	$	10,079,811	$	1,616,425		$	—		$	11,696,236
2003:
Revenues:
External customers	$	1,039,835	$	32,860		$	—		$	1,072,695
Intersegment		11,855		—			(11,855	)		—
Total revenues	$	1,051,690	$	32,860		$	(11,855	)	$	1,072,695
Income before income taxes:
External customers	$	893,446	$	22,651		$	—		$	916,097
Intersegment		11,855		(2,088	)		(9,767	)		—
Total income before income taxes	$	905,301	$	20,563		$	(9,767	)	$	916,097
Identifiable assets	$	8,234,065	$	1,499,171		$	—		$	9,733,236
2002:
Revenues:
External customers	$	821,670	$	18,502		$	—		$	840,172
Intersegment		1,329		—			(1,329	)		—
Total revenues	$	822,999	$	18,502		$	(1,329	)	$	840,172
Income before income taxes:
External customers	$	716,131	$	13,246		$	—		$	729,377
Intersegment		1,329		(1,329	)		—			—
Total income before income taxes	$	717,460	$	11,917		$	—		$	729,377
Identifiable assets	$	7,035,850	$	1,159,530		$	—		$	8,195,380

35

AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollar Amounts in Thousands)

The following table summarizes gross premiums written and net premiums earned and other credit enhancement fees included in the financial guarantee segment, by location of risk for the years ended December 31, 2004, 2003 and 2002.

	2004		2003		2002
Gross premiums written:
United States	$	820,632	$	917,946	$	770,883
United Kingdom		110,225		106,315		38,495
Japan		28,836		25,783		22,033
Mexico		15,007		16,395		16,513
Italy		11,690		12,842		860
Brazil		10,846		10,193		7,239
Australia		5,026		4,761		8,930
Internationally diversified		30,062		30,536		17,594
Other international		17,890		24,401		26,343
Total:	$	1,050,214	$	1,149,172	$	908,890
Net premiums earned and other credit enhancement fees:
United States	$	558,877	$	503,355	$	387,714
United Kingdom		60,731		34,993		19,287
Japan		32,141		25,965		17,941
Mexico		7,242		7,620		7,720
Italy		8,003		6,487		777
Brazil		8,282		6,978		4,827
Australia		7,246		5,493		4,945
Internationally diversified		56,906		59,082		41,679
Other international		30,809		23,633		21,477
Total:	$	770,237	$	673,606	$	506,367

Internationally diversified includes components of domestic exposure.

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